THE  LIBRAPvY 

OF 

THE  UNIVERSITY 

OF  CALIFORNIA 

RIVERSIDE 


Public  Utility  Rate  Fixing 


COMMENTS 

on  Current  Problems  Pertaining  to 
PUBLIC  UTILITIES 

and  to 

RATE  FIXING 


By 

C.  E.  GRUNSKY,  Eng.  D. 

Consulting  Civil  Engineer 

Member    Am.    Soc.    C.   E.;     President    American    Engineering    Corporation ; 

President  California  Academy  of  Sciences ;    Author  of  "  Valuation 

Depreciation  and  the  Rate  Base,"    "Topographic   Stadia 

Surveying,"  etc. 


TECHNICAL   PUBLISHING   COMPANY 
SAN   FRANCISCO 

1918 


Copyright  1918 

by 
Technical  Publishing  Company 


PUBLIC  UTILITY   RATE  FIXING 


THE   1918  TECHNICAL  SERIES 

Public  Utility  Rate  Fixing 

By  C.  E.  Grunsky $2.50 

Elements  of  Western  Water  Law  (revised) 

By  A.  E.   Chandler $2.50 

Elements  of  Fuel  Oil  and  Steam  Engineering 

By  Robert  Sibley  and  Chas.  H.  Delany $3.00 

TECHNICAL  PUBLISHING  COMPANY 

Crossley  Building,   San  Francisco 


CONTENTS 


CHAPTER  I  Page 

General   Comments  on   Rate   Fixing 1 

Accrued  depreciation  should  not  affect  rates — The  rate  base 
and  the  natural  rate  base — Legitimate  earnings — The  Knox- 
ville  Waterworks  case  with  reference  to  past  history  of  public 
utility,  ordinary  assumption  that  capital  has  been  retired  not 
justified — Adequate  earnings  include  profit — Gross  annual  in- 
come as  basis  for  profit  allowance — The  replacement  require- 
ment— Accrued  depreciation  non-essential  in  rate  fixing — 
The  bonus  and  the  rate  base — Cost  and  value  of  water  rights 
in  their  relation  to  the  rate  base-^Appreciation  in  relation  to 
the  rate  base — Illustrations  showing  practical  application  of 
some  fundamental  principles — Investment  as  a  rate  base  con- 
trasted with  value — Interests  of  the  owner,  the  rate  payer 
and  the  public — Difficulty  of  ascertaining  depreciation. 

CHAPTER    II 

Elements   Deserving   Special   Consideration  When   Rates 
are  to  be  Fixed 34 

A.  Obsolescence  34 

Obsolescence  cannot  be  predicted — Treatment  of  obsolescence 
and  replacement  compared — Obsolescence  should  affect  rates 
after,  not  before  the  event — Illustration. 

B.  Losses  from  Fortuitous  Events 39 

Amortization    of    losses    from    fortuitous    events. 

C.  Hazard,  Management  and  the  Unearned  Increment     41 

The  allowance  for  hazard  for  the  unearned  increment  and  for 
management  should  not  be  based  on  value — Volume  of  busi- 
ness to  be  considered. 

D.  Volume  of  Business 46 

Public   utility   rates   and   the   volume   of   business. 

E.  Going    Value 49 

Going  value  in  the  San  Francisco  water  rate  case — Determina- 
tion of  going  value — Cost  of  establishing  business  is  not 
going  value — Going  value  the  result  of  earnings. 

CHAPTER  III 
Appraisal  of  Real  Estate  Adapted  to  Special  Use 59 

The  value  of  reservoir  lands — Circumstances  affecting  the  value 
of  land  -Factors  to  be  considered  in  determining  the  market 
value  of  reservoir  land — Appreciation  of  land  value — Increas- 
ing land  values  in  the  San  Francisco  Bay  region  Tables  and 
diagrams  showing  population  and  real  estate  valuation  in 
California  and  the  San  Francisco  Bay  region  —Court  decisions 
on  reservoir  land  value  in  the  San  Francisco  Bay  region. 

CHAPTER   IV 

Determination  of  the  Value  of  Real  Estate  in  Eminent 
Domain  Proceedings 81 

All  possible  uses  must  be  considered  -Reference  to  court  decis- 
ions— The  value  multiple. 


CHAPTER    V  Page 

Depreciation   and   Appreciation 90 

The  depreciation  problem — Mathematical  demonstration  of  defi- 
ciency of  ordinary  formulas — Determination  of  the  current 
replacement  is  essential — Appreciation  in  relation  to  rates — 
Appreciation  referred  to  in  court  and  Public  Service  Commis- 
sion decisions — The  Interstate  Commerce  Commission  has  diffi- 
culty in  dealing  with  appreciation — Treatment  of  Depreciation 
and  appreciation  compared. 

CHAPTER   VI 

The  Value  of  a  Water  Right 101 

Recognition  of  value — Regional  cost  of  development  consid- 
ered— Strategic  value — Water  power  development  should  be 
encouraged — The  life  of  the  right  affects  its  value — Earnings 
create  value — The  San  Francisco  rate  case — Comparison  with 
other  water  rights — Mutual  water  company  stock  sales  as  an 
aid  in  determining  the  value  of  water  rights — The  enhanced 
value  of  irrigated  land  in  relation  to  the  value  of  water 
rights — The  obligation  to  supply  water  at  less  than  cost. 

CHAPTER   VII 
The   Rate   of   Return 121 

Protection  of  the  investment — Other  factors  besides  the  rate 
of  return  on  the  legitimate  investment — Rate  of  return  de- 
fined— The  obligation  of  the  public  when  it  regulates — Rate 
of  return  illustrations — The  Spring  Valley  Water  Company 
rate  case. 

CHAPTER    VIII 
The  Rate  Schedule 135 

Unit  prices  to  consumers  not  uniform — Some  problems  for 
consideration  The  unearned  increment  as  a  factor — Determin- 
ing factors-  The  remission  of  taxes — Rates  for  electric 
energy  —  Gas  and  Water  rates — Street  oar  fare — The  zone  sys- 
tem— Essentials  in  street  car  operation — The  railroad  rate 
schedule-  The  long  and  short  haul  question — Artificial  com- 
petition with  water  transportation  —The  government  owner- 
ship problem. 

CHAPTER   IX 

The   Public    Utility    Rate    Base  .  151 

Value  as  a  rate  base  illogical  The  natural  rate  baso-  Restric- 
tions imposed  by  court  decisions  Appreciation  and  the  rate 
base. 

CHAPTER   X 

Fair  Value  and   the   Rate   Base,   by   C.   E.    Grunskv,  Jr., 
Capt.    U.    S.    X.    A .: *. 156 

Special  committee  of  Am.  Soc.  C.  E.  on  "fair  value"  and  "fair 
return"  Functions  of  rate  fixing  authorities  and  of  courts 
not  the  same  The  use  of  value  when  fixing  rates  imprac- 
ticable A  satisfactory  rate  base  The  present  situation. 

Index 165 


PREFACE 


A  number  of  articles  dealing  with  the  problem 
of  fixing  public  utility  rates  and  related  matters, 
originally  contributed  to  the  Journal  of  Electricity, 
have  been  assembled  in  this  volume.  One,  by  Capt. 
C.  E.  Grunsky,  Jr.,  entitled  "Fair  Value  and  the 
Rate  Base"  has  been  included  and  will  be  found  at 
the  end  of  the  volume.  As  these  articles  are  here 
reproduced  from  the  original  plates,  this  fact  will 
sufficiently  explain  what  might  otherwise  be  classed 
as  too  frequent  repetition  of  certain  fundamental 
truths,  such  as  the  statement  that  it  is  illogical  to 
make  "value"  which  results  from  the  earnings  and 
therefore,  too,  from  the  rates,  the  basis  of  the  calcu- 
lation when  rates  are  to  be  fixed.  That  some  of  the 
ideas  here  presented  may  prove  helpful  to  those  who 
are  engaged  in  determining  fair  rates  for  the  output 
of  public  utilities  or  in  prescribing  methods  of  pro- 
cedure when  rates  are  to  be  fixed,  and  that,  the  war 
having  ended,  this  little  volume  may  assist  in  the 
solution  of  some  of  the  economic  problems  which  will 
arise  in  the  readjustment  of  affairs  to  peace  condi- 
tions, is  the  hope  of  the  author. 

C.  E.  GRUNSKY. 
San  Francisco,  Cal. 
December  1,  1918. 


There  is  no  public  rcsn 
Its  utilization  conscrv 
i-Mcouraeed  hy  liberal 
control  by  the  KOVITIHI 
lion  and  the  consumer 


rce  more  worthy  of  early  development  than  water  power. 
*  the  nation's  fuel  supply.  Private  capital  should  he 
erms  which  can  be  done  without  surrendering  ultimate 
nt  in  the  interest  nf  the  public.  Society  demands  ulili/a- 
can  afford  and  is  willing  to  pay  the  rates. 


PUBLIC  UTILITY  RATE  FIXING 

CHAPTER  I 
GENERAL  COMMENTS  ON  RATE  FIXING 

The  writer  has  recently  been  asked  to  define  his 
views  on  the  rate  regulation  of  public  utilities  with 
special  reference  to  the  earnings  which  should  be 
allowed  to  the  public  utility  corporation.  In  doing 
so  he  will,  for  convenience,  refer  to  and  quote  in  a 
limited  measure  from  some  of  his  publications  on  the 
subject  of  valuation  for  rate-fixing  purposes  and  re- 
lated matters. 

For  25  years  he  has  had  to  give  more  or  less  atten- 
tion to  rate  regulation  and  his  views  on  some  of  the 
more  important  features  to  be  considered  were  definite- 
ly crystallized  when  as  city  engineer  of  San  Francisco, 
1900  to  1904,  he  made  appraisals  of  the  properties  of 
the  Spring  Valley  Water  Company.  He  was  from 
the  outset  so  firmly  convinced  that  accrued  deprecia- 
tion is  not  an  element  for  consideration  when  rates 
are  to  be  fixed  that  he  has  at  all  times  adhered  to 
this  principle  and  in  1912  he  contributed  to  the  Amer- 
ican Society  of  Civil  Engineers1  a  paper  on  "The  Ap- 
praisal of  Public  Service  Properties  as  a  Basis  for 
the  Regulation  of  Rates,"  to  demonstrate  its  sound- 
ness. He  found  it  desirable,  for  the  benefit  of  the 
profession,  to  do  this,  because  the  rate  regulating 
authorities  were  generally  accepting  without  protest 
the  view,  laid  down  by  the  courts,  that  "value"  must 
be  the  basis  of  the  calculation  when  the  sufficiency  of 
a  rate  is  in  question.  Concerning  the  above  paper 
of  1^12, — the  theory  laid  down  in  which  has  gone  un- 
challenged,— Mr.  J.  \V.  Alvord  says2: 


'Transactions   Am.    Poc.    C.    E.   Vol.    KXXV,    p.    770, 
'Transactions  Am.   Soc.   C.   E.   Vol   LXXIX,  p.   232. 


2  PUBLIC     UTILITY     RATE     FIXING 

"The  question  of  deducting  depreciation  from  cost  new, 
however,  is  fundamental  to  a  proper  value,  and,  as  a  matter 
of  fact,  for  the  past  15  years,  engineers  and  attorneys  have 
been  arguing  for  its  deduction,  and  courts  have  been  ap- 
proving the  practice  of  subtracting  the  depreciation  from 
reproduction  cost  new  in  every  case  brought  before  them, 
without  a  single  exception  which  the  writer  can  recall.  En- 
gineering appraisal  boards,  so  far  as  the  writer  is  aware, 
have  pursued  the  same  practices.  In  water-works  appraisal, 
the  question  was  discussed  and  settled  more  than  15  years 
ago,  and  has  never  been  seriously  controverted  since,  until 
Mr.  Grunsky's  paper  *  *  *  appeared  in  1912,  before 
this  Society." 

It  is  self  evident  that  the  service  rendered  by, 
or  the  output  of  any  public  utility  does  not  deterioate 
as  the  result  of  aging  of  the  plant.  If  there  is  any 
change,  the  advantage  should  be  with  the  long  estab- 
lished plant  which  should  render  a  more  dependable 
and  better  service  than  a  new  plant.  The  value  to  the 
consumer  of  the  service  or  of  the  output  is  in  no 
way  affected  by  the  accruing  depreciation.  It  is  as- 
sumed of  course  that  a  well  maintained  plant  is  under 
consideration  which  shows  no  deferred  maintenance. 

Accrued  Depreciation  Should  Not  Affect  Rates 

The  establishment  of  rates,  therefore,  should  be  in- 
dependent of  accrued  depreciation.  The  rates  found 
to  be  proper  for  a  new  plant  should  be  equally  appro- 
priate for  a  plant  which  has  been  long  in  service.  It 
follows  that  some  other  procedure  is  desirable  than 
the  one  which  has  apparently  been  laid  down  by  the 
courts. 

Furthermore,  it  is  illogical  to  require  that  value 
in  any  form  be  made  the  starting  point  when  rates  or 
reasonable  earnings  are  to  be  determined  because 
value  is  a  result  of  the  earnings  and  can  not  be  made 
a  premise.  The  courts  make  inquiry  relating  to  value 
because  they  are  concerned  in  determining  whether 
or  not  the  earnings  are  adequate  to  protect  the  value. 
The  rate-fixing  authorities,  on  the  other  hand,  are  free 
to  use  any  method  that  to  them  seems  proper  in  de- 
termining the  required  earnings  of  any  public  utility. 
They  need  not  apply  the  value  test.  They  should, 


GENERAL     COMMENTS  3 

moreover,  adopt  the  simplest  and  most  direct  method 
of  procedure.  This  the  writer  has  repeatedly  pointed 
out,  but  finds  it  difficult  to  make  plain  to  the  old 
line  economists  and  valuation  experts,  that  as  a 
starting  point,  despite  the  decisions  of  the  courts,  a 
rate-base  can  be  used  which  is  not  value.  Even  Mr. 
Alvord  assumes  that  the  writer's  appraisal  of  a  rate- 
base  undiminished  by  depreciation  represents  value. 
A  clear  distinction  should  be  made  between  the  writer's 
"natural  rate-base"  determined  from  legitimate  invest- 
ment, for  example,  and  the  "fair  value"  or  "present 
value"  which  is  so  commonly  used  as  the  starting 
point.  Although  so-called  "fair  value"  has  been  very 
generally  used  as  a  rating  base,  this  does  not  mean  that 
rate-base  and  value  should  be  regarded  as  synonymous. 
The  rate-base  may  be  quite  as  distinct  from  value 
as  original  cost  is  distinct  from  value. 

The  Rate-base  and  the  Natural  Rate-base 

To  make  this  clear  it  is  necessary  to  keep  in  mind 
that  the  rate-base  is  any  sum  to  which  a  rate  of  in- 
terest is  applied  in  determining  the  interest  increment 
which  should  be  covered  by  the  earnings. 

For  example  in  the  case  of  a  steamboat,  whose 
owner  may  have  made  no  other  investment  of  capital 
than  in  the  steamboat,  the  service  rendered  to  those 
who  ship  freight  on  the  boat  or  who  travel  on  the  same 
is  worth  no  more  nor  less  if  rendered  by  a  new  boat, 
than  if  it  were  rendered  by  a  boat  which  has  already 
been  in  service  one-half  of  its  probable  life  term. 

The  natural  rate-base  in  this  case  is  the  amount 
invested  in  a  new  steamboat  or,  expressed  in  the  usual 
way,  the  legitimate  investment,  undiminished  by  de- 
preciation. On  this  rate-base  the  owner  will  be  en- 
titled to  interest  at  a  fair  rate  covering  at  least  the 
amount  which  a  responsible  owner  would  have  to 
pay  for  borrowed  money  and  he  will  also  be  entitled 
to  such  renewal  or  replacement  increments  as  will, 
if  held  inviolable  for  this  purpose,  replace  the  steamer 
with  a  ne\v  one  when  it  ceases  to  be  useful.  But  if 
the  owner  were  not  allowed  to  earn  more  than  these 


4  PUBLIC     UTILITY    RATE    FIXING 

interest  and  replacement  increments  in  addition  to 
cost  of  operation,  he  would  not  be  in  the  business.  He 
is  entitled  also  to  a  profit  which  while  not  exorbitant 
should  yet  be  such  in  amount  that  this  and  similar 
enterprises  will  be  encouraged  and  not  discouraged. 

The  earnings  required  to  meet  interest  and  re- 
placement apart  from  profit  and  operating  expenses, 
would  be  estimated  as  below  shown,  if  the  interest  rate 
to  be  allowed  is  7  per  cent  and  the  steamboat  which, 
new,  had  an  expectancy  of  20  years  is  now  estimated  to 
serve  for  10  years  longer: 

For  each  $100  of  original  investment  in  the  steam- 
boat: 

Interest  on  the  rate-base  7  per  cent  on   $100 $7.00 

Replacement    requirement,    computed    from    probable    life, 

7   per  cent    2.44 

Total    $9.44 

To  the  allowances  thus  computed  on  the  entire  in- 
vestment there  are  to  be  added  the  ordinary  operating 
expenses  and  also  profit. 

If  the  practice  of  deducting  accrued  depreciation 
from  the  value  of  physical  properties  be  followed  the 
computation  would  be  as  follows  (again  without  in- 
clusion of  the  operating  expenses  and  the  profit  allow- 
ance) : 

Original  investment $100.00 

Accrued    depreciation    when    the   remaining   life   of 

the  steamboat  is  10  years,  interest  7  per  cent.      33.70 


Rate-base   (so-called  present  value $   66.30 

Interest    on    the    rate-base    (present    value    of    each    $100 

of  original   investment)    7   per  cent   on   $66.30 $      4.64 

Replacement  requirement,  being  the  amount  to  be  earned 
annually  to  retire  the  so-called  present  value  in  the 
remaining  years  of  the  steamboat's  life,  ($66.30  in 
ten  years,  7  per  cent  interest) 4.80 


Total    $     9.44 

In  the  one  method  of  procedure  a  rate-base  is  used 
which  may  depart  widely  from  the  value  of  the  steam- 
boat, in  the  other  method  the  depreciated  value  of  the 
steamboat  is  introduced  and  this  is  made  the  rate-base. 

In  practice,  however,  to  care  for  the  profit  element 
it  has  become  customary  to  add  to  the  present  value 
of  physical  properties  the  value  of  certain  intangible 
elements,  so  that  in  the  great  majority  of  utilities, 


GENERAL    COMMENTS  5 

made  up  of  many  items,  the  present  value  as  used  may 
be  raised  to  or  even  beyond  the  natural  rate-base  de- 
termined from  legitimate  original  investment  un- 
diminished  by  depreciation. 

The  aggregate  value  thus  approximated  may  be  a 
more  or  less  arbitrary  amount  on  which  the  rate  of 
return  is  to  be  interest  plus  profit,  or  it  may  be  the 
actual  value  which  it  is  planned  should  result  from 
a  capitalization  of  net  earnings  at  the  interest  rate 
at  which  money  is  obtainable  for  the  type  of  utility 
under  consideration,  due  regard  being  had  to  neces- 
sary discounts  and  commissions.  If  this  interest  rate 
is  7  per  cent  there  would  in  the  first  case,  a  rate  of 
return  be  allowed  of  perhaps  8  per  cent  or  9  per  cent, 
of  which  1  per  cent  or  2  per  cent,  as  the  case  may  be, 
would  represent  a  profit  in  addition  to  the  interest  on 
that  part  of  the  intangible  values  known  as  "going 
value."  In  the  second  case  the  "going  value"  would 
be  represented  by  the  owners  capitalized  profit  and  the 
allowed  rate  of  return  would  be  not  less  than  7  per 
cent  though  possibly  no  more.  Conversely,  in  this  case, 
the  interest  on  the  intangible  element  "going  value" 
would  be  the  profit  allowance. 

Legitimate  Earnings 

The  earnings  of  every  public  utility  should  be 
adequate 

(a)  To  yield  a  proper  interest  return  on  the  cap- 
ital which  has  been  legitimately  invested  in  the  enter- 
prise; 

(b)  To  renew  essential  items  of  the  property  when 
for   any   reason    the    items   which    have   been    in    use 
must  be  abandoned; 

(c)  To  meet  operating  expenses,  including  taxes, 
overhead,    and    all    repair    and    maintenance    require- 
ments ; 

(d)  To   yield    a   profit,    as    compensation   to    the 
owner  for  management  and  hazards,  and  as  a  share  in 
general  prosperity ; 

(e)  In  exceptional  cases  to  retire  the  invested  cap- 
ital in  whole  or  in  part  when  the   life  of  the   utility 
is  limited; 


6  PUBLIC    UTILITY    RATE     FIXING 

(f)  To  amortize  early  losses  or  other  legitimate 
sacrifices  made  by  the  owner  and  not  proper  for  in- 
clusion in  the  rate-base. 

The  legitimate  original  investment  is  not  meas- 
ured by  original  cost.  This  cost  is  to  be  taken  into 
account,  but,  according  to  circumstances,  remains  sub- 
ject to  correction.  The  term  investment  as  here  used 
is  understood  to  include  actual  cost  of  franchises  and 
water-rights  and  strategic  values  of  the  same  but  not 
the  intangible  element  of  going  value.  The  latter,  as 
above  stated,  is  the  result  of  the  profits  of  the  business. 
Under  certain  circumstances  the  cost  of  reproduction, 
including  an  allowance  for  the  cost  of  developing  the 
business,  will  be  the  best  guide  in  determining  the 
legitimate  investment,  therefore,  the  natural  rate-base. 

The  Knoxville  Waterworks  Case  with  Reference  to 
Past  History  of  Public  Utilities 

The  writer  is  not  in  accord  with  those  who  accept 
the  principle  laid  down  in  the  Knoxville  Waterworks 
case  by  the  Supreme  Court  of  the  United  States,3 
to  the  effect  that  past  earnings  should  be  assumed  to 
have  been  adequate,  when  it  says: 

"A  water  plant,  with  all  its  additions,  begins  to  depre- 
ciate in  value  from  the  moment  of  its  use.  Before  coming 
to  the  question  of  profit  at  all  the  company  is  entitled  to 
earn  a  sufficient  sum  annually  to  provide  not  only  for  current 
repairs,  but  for  making  good  the  depreciation  and  replacing 
the  parts  of  the  property  when  they  come  to  the  end  of 
their  life.  The  company  is  not  bound  to  see  its  property 
gradually  waste,  without  making  provision  out  of  earnings 
for  its  replacement.  It  is  entitled  to  see  that  from  earn- 
ings the  value  of  the  property  invested  is  kept  unimpaired, 
so  that,  at  the  end  of  any  given  term  of  years  the  original 
investment  remains  as  it  was  at  the  beginning.  It  is  not 
only  the  right  of  the  company  to  make  such  a  provision, 
but  it  is  its  duty  to  its  bond  and  stock  holders,  and,  in  the 
case  of  a  public  service  corporation,  at  least,  its  plain  duty 
to  the  public.  If  a  different  course  were  pursued,  the  only 
method  of  providing  for  replacement  of  property  which  has 
ceased  to  be  useful  would  be  the  investment  of  new  capital 
and  the  issue  of  new  bonds  or  stocks.  This  course  would 


»212   U.   S.   Reports   1;    29    Sup.   Ct.   Rep.    148. 


GENERAL    COMMENTS  7 

lead  to  a  constantly  increasing  variance  between  present 
value  and  bond  and  stock  capitalization — a  tendency  which 
would  inevitably  lead  to  disaster  either  to  the  stockholders 
or  to  the  public,  or  both.  If,  however,  a  company  fails  to 
perform  this  plain  duty  and  to  exact  sufficient  returns  to 
keep  the  investment  unimpaired,  whether  this  is  the  result 
of  unwarranted  dividends  upon  over  issues  of  securities,  or 
of  omission  to  exact  proper  prices  for  the  output,  the  fault 
is  its  own.  When,  therefore,  a  public  regulation  of  its  prices 
comes  under  question,  the  true  value  of  the  property  then 
employed  for  the  purpose  of  earning  a  return  cannot  be 
enhanced  by  a  consideration  of  the  errors  of  management 
which  have  been  committed  in  the  past." 

According  to  the  view  here  expressed  by  the  court 
every  public  utility  should  at  once  upon  the  begin- 
ning of  operation  earn  enough,  not  alone  to  recover 
interest  on  its  investment,  but  also  to  retire  the  va- 
rious articles  in  use,  each  within  its  term  of  useful- 
ness. This  is  manifestly  impossible  because  in  the 
great  majority  of  cases  the  rate-payers  will  be  few  at 
the  beginning  of  operation  and  it  would  be  imprac- 
ticable to  exact  from  them  rates  that  would  produce 
earnings  determined  by  such  a  requirement.  There 
will  be  lean  years,  years  during  which  additional  sac- 
rifice will  be  demanded  from  the  owner.  Such  sacri- 
fice he  must  make  to  establish  his  business  on  a  pay- 
ing basis.  Consideration  must  be  given  to  this  situa- 
tion and,  in  determining  the  legitimate  investment, 
it  is  proper  to  include  therein  a  fair  amount  for  the 
cost  of  developing  business. 

To  ignore  past  history  of  the  utility  and  to  assume 
that  if  the  owner  has  not  exacted  an  adequate  return 
it  is  his  own  fault,  appears  to  the  writer  unfair. 

In  connection  with  the  decision  of  the  U.  S.  Su- 
preme Court  in  the  Knoxville  Water  Co.  case  the 
writer  makes  the  following  comment  in  his  book  on 
"Valuation,"4  p.  135: 

"Past  history  cannot  be  ignored  if  rates  are  to  be  so 
fixed  as  to  be  fair  alike  to  the  owner  and  to  the  rate-payer. 
In  other  words,  not  all  shortage  of  earnings  in  the  past  is, 
to  be  ascribed  to  errors  of  management.  It  is  difficult  to  re- 


*"Valuatlon,   Depreciation   and    the   Rate-Base." 


8  PUBLIC     UTILITY    RATE     FIXING 

concile  the  language  of  the  court  with  this  principle  even  as 
it  is  difficult  to  understand  why  so  many  of  the  courts  have 
held  that  value  which  results  from  earnings  must  be  made 
the  starting  point  when  rates  are  to  be  fixed." 

Sometimes,  of  course,  the  situation  is  presented 
of  past  earnings  that  were  beyond  all  reason.  The 
principle  of  "all  the  traffic  will  bear"  may  have  been 
misapplied  by  the  owner  and  it  may  be  that  not  only 
what  should  have  gone  into  a  replacement  fund,  but 
more  was  actually  collected  from  the  rate-payers  and 
that  this  excess  as  well  as  what  should  be  in  a  re- 
placement fund,  was  distributed  as  dividends,  there- 
by leaving  the  property  in  an  impaired  condition.  It 
is  not  to  be  understood  from  this  statement,  how- 
ever, that  profits,  that  is,  earnings  in  excess  of  an 
allowable  interest  return,  are  in  all  cases  to  be  con- 
strued as  having  been  available  for  the  retirement  of 
capital  or  as  a  replacement  fund.  Even  when  there  is 
some  profit  the  utility  might  still  fall  short  of  ful- 
filling expectations,  because  both  the  original  owner, 
and  his  successors,  were  and  are  entitled  to  more 
than  a  bare  interest  return  on  the  sacrifice  which  they 
have  made  in  establishing  and  maintaining  the  utility. 

In  the  case  of  the  complex  long  established  cor- 
poration-owned utility,  which  is  about  to  be  brought 
under  review  for  the  purpose  of  having  its  rates  reg- 
ulated, the  presumption  should  be  that  fair  or  even 
large  profits  in  the  past  were  legitimate  and  that 
having  been  absorbed  in  the  dividend  distributions 
to  former  stockholders,  it  would  be  unwise,  as  well 
as  unfair  to  the  present  stockholders,  to  make  the  as- 
sumption that  a  part  of  these  past  earnings,  usually 
taken  as  equal  to  the  accrued  depreciation,  should  all 
at  once  be  deducted  from  original  investment  when 
setting  a  limit  to  the  value  which  the  earnings  will  be 
allowed  to  create.  The  unfairness  or  injustice  of  such  a 
procedure  has  been  generally  recognized  with  the  result 
that  the  allowance  in  the  rate-base  for  intangible  ele- 
ments, particularly  for  "going  value"  is  contended  for 
by  most  valuation  experts  and  is  generally  allowed, 
although  none  but  arbitrary  methods  of  determining 
the  amount  thereof  have  as  yet  been  suggested. 


GENERAL    COMMENTS  9 

Ordinary  Assumption  that  Capital  Has  Been  Retired 
Not  Justified 

Ordinarily,  therefore  a  procedure  should  be 
adopted  based  on  the  assumption  that  a  utility,  of  the 
complex  permanent  character,  has  not  retired  any 
capital.  Its  earnings  have  been  used  to  make  repairs 
and  replacements  of  abandoned  property,  keeping  the 
utility  at  100%  efficiency,  also,  to  pay  interest  and 
profit  to  the  owners.  The  utility  should  be  assumed  to 
have  been  conducted  exactly  as  would  be  expected  if  it 
had  perpetual  life.  Some  such  assumption  must  be  made 
as  an  aid  in  determining  the  treatment  to  which  the 
utility  is  entitled  when  its  rates  are  fixed  for  the  future. 
If  depreciated  value  of  physical  elements  is  made  the 
starting  point  this  could  only  be  predicated  on  the  as- 
sumption that  to  the  extent  of  the  accrued  depreciation, 
capital  has  been  retired  out  of  earnings.  But  such  an 
assumption  is  just,  only  in  cases  where  the  fact  is  ob- 
vious. Otherwise  the  proceeding  should  be  to  intro- 
duce into  the  calculation,  a  rate-base  representing 
legitimate  original  investment,  as  already  defined,  un- 
diminished  by  depreciation,  and  to  allow  in  the  earn- 
ings such  a  replacement  increment  as  will  make  ade- 
quate provision  for  the  renewal  or  replacement  of 
each  item  of  property  as  the  same  becomes  useless 
and  is  abandoned. 

Adequate  Earnings  Include  Profit 

But  when  a  rate-base  is  thus  determined  and  an 
interest  return  is  applied  to  the  same  which  will  prop- 
erly compensate  the  owner  for  the  use  of  his  money 
(due  allowance  being  made  for  discounts  and  com- 
missions) some  provision  must  be  made  to  give  him, 
in  addition  thereto,  compensation  for  management,  and 
for  hazards,  and  also  to  give  him  a  share  in  the  general 
prosperity  of  the  community,  because  this  prosperity 
must  in  part,  be  ascribed  to  the  installation  and  opera- 
tion of  the  utility.  This  reward,  as  already  intimated, 
usuaally,  though  awkwardly,  makes  its  appearance  in 
the  allowance  for  ''going  value"  and  in  the  appreciation 
of  real  estate  and  other  properties  where  value  in- 
creases with  age,  and  also  in  a  rate  of  return  so  fixed 


10  PUBLIC    UTILITY    RATE     FIXING 

that  it  will  exceed  in  some  measure  a  bare  interest 
return.  By  this  addition  to  the  interest  rate  the  at- 
tempt is  made  to  bring  profit  into  some  relation  to  the 
value  of  the  utility.  This  does  not  work  well  pe- 
cause  one  utility  may  be  of  a  type  requiring  a  large 
investment  to  secure  a  given  amount  of  revenue, 
while  another  may  secure  the  same  revenue  on  a 
trifling  investment.  There  is,  in  other  words,  some- 
thing else  to  be  brought  into  the  calculation  besides 
a  rate-base.  The  writer  in"Valuation,  Depreciation  and 
the  Rate-Base,"  p.  160  says  : 

"While  it  is  important  to  establish  a  rate-base  whenever 
rates  are  to  be  fixed,  there  may  be  cases  in  which  other  cir- 
cumstances are  of  equal  moment  with  the  rate-base  as  a 
guide  to  the  allowable  earnings.  It  may  happen  that  the 
public  service  requires  only  a  small  investment  of  capital 
compared  with  the  volume  of  the  business  that  is  transacted, 
and  it  may  then  be  more  desirable  and  equitable  to  bring 
the  compensation  of  the  owner  into  some  relation  to  the 
volume  of  business  transacted  rather  than  to  the  capital 
which  is  invested  in  the  business. 

"The  case  may  readily  be  conceived  of  a  concern  such 
as  an  express  company  which  rents  its  office  facilities  and 
operates  under  contract  with  railroad  and  steamship  com- 
panies and  which,  outside  of  its  trucks  and  other  vehicles 
for  the  local  distribution  of  the  parcels  entrusted  to  its  care, 
has  made  no  investment  of  any  moment.  It  would  be  vain 
in  such  a  case  to  attempt  a  regulation  of  rates  based  solely 
upon  a  fair  return  upon  the  invested  capital.  The  whole  field 
must  be  brought  into  view.  The  volume  of  business  trans- 
acted, and  the  value  that  would  be  created  if  earnings  are 
allowed  which  exceed,  in  some  definite  fashion,  the  cost  of 
conducting  the  business,  should  receive  due  consideration. 
If  earnings  are  thus  allowed  which  exceed  the  cost  of  opera- 
tion by  10  to  15  per  cent,  this  would  not  seem  unreason- 
able unless  the  resulting  rates  are,  in  fact,  more  than  the 
traffic  can  or  should  bear." 

Gross  Annual  Income  as  Basis  for  Profit 
Allowance 

It  need  only  be  added  that  such  a  profit  allowance 
as  here  suggested  might  well  be  graduated  accord- 
ing to  the  gross  annual  income,  making  the  allow- 
ance larger,  perhaps  15  per  cent  for  the  smaller  con- 


GENERAL     COMNENTS  11 

cern  and  dropping  materially  below  10  per  cent  when 
earnings  of  $10,000,000  to  $100,000,000  per  annum  and 
more  are  under  consideration. 

There  will,  however,  be  special  cases  when  even 
such  profit  allowances  as  here  suggested  will  be,  at 
least  temporarily,  inadequate.  Let  it  be  supposed  for 
example  that  the  owner  of  the  utility  has  made  an 
invention  or  can  secure  the  right  to  use  an  invention, 
by  the  introduction  of  which  he  can  materially  reduce 
the  cost  of  operation,  but  that  the  introduction  of 
the  invention  involves  the  abandonment  of  property 
which  would,  except  for  the  innovation,  have  remained 
long  in  service.  Under  any  hard  and  fast  rule  that  no 
property  value  shall  be  included  in  the  rate-base  ex- 
cept it  be  in  use,  there  would  be  a  sacrifice  by  the 
owner  represented  by  the  former  value  of  the  discarded 
property.  Furthermore,  cost  of  operation  being  taken 
into  account  and  this  cost  being  reduced,  there  would 
be  good  ground  for  a  corresponding  reduction  of  rates. 
If  such  a  reduction  be  made  to  the  full  extent  of  the 
reduction  in  operating  expenses,  the  entire  benefit  of 
the  invention  would  go  to  the  rate-payer  and  the  owner 
might  find  himself  penalized  to  the  extent  of  the  value 
of  the  abandoned  property.  The  proper  proceeding 
in  such  a  case  is  to  allow  to  the  owner  the  benefit 
resulting  from  the  reduction  of  operating  cost,  for 
a  certain  time,  long  enough  at  least,  to  let  the  benefit 
amortize  or  retire  the  investment  in  so  much  of  the 
property  as  is  rendered  useless,  the  owner  finds  it  to 
his  advantage  to  lower  his  prices  for  the  purpose  of 
increasing  his  business  and  thereby  augmenting  his 
net  earnings,  and  thereafter,  to  divide  the  benefit  be- 
tween the  owner  and  the  rate-payer  on  a  mutually 
advantageous  basis,  which  will  be  done  by  introducing 
a  larger  profit  allowance  into  the  calculation  than 
would  be  there  under  ordinary  circumstance,  and  yet 
not  so  large  as  to  deprive  the  rate-payer  of  some 
share  in  the  benefit  which  has  resulted  from  the  use  of 
the  invention. 


12  PUBLIC     UTILITY     RATE     FIXING 

The  Replacement  Requirement 

There  is  yet  another  question  that  arises  whenever 
the  amount  of  allowable  earnings  is  to  be  determined 
for  a  public  utility.  This  relates  to  the  allowance 
which  should  be  made  for  replacement  or  renewal  re- 
quirements, or,  as  some  valuation  experts  would 
say,  for  "current  depreciation."  If  the  property  is  all 
new  and  if  conditions  are  such  that  any  earnings  de- 
termined to  be  reasonable  and  proper  will  actually  ma- 
terialize in  the  income  from  the  beginning  of  oper- 
ation, then  it  will  be  proper  to  proceed  according  to 
sinking  fund  methods  using  the  same  rate  of  interest 
as  is  applied  to  the  rate-base.  The  replacement  incre- 
ments must  then  be  placed  in  a  fund,  or  will  at  least 
appear  on  the  books  to  be  in  a  fund,  and  the  earnings 
of  this  fund  must  be  held  inviolable  for  use  in  sup- 
plementing the  annual  replacement  increments.  The 
fund's  earnings,  plus  these  increments,  if  assumptions 
as  to  probable  life  of  the  items  of  the  plant  have  been 
correct,  will  be  just  sufficient  to  make  renewals  as 
these  may  be  required. 

As  an  alternative  to  this  method  of  procedure  the 
practice  may  be  followed, — a  new  plant  being  again 
under  consideration — of  allowing  the  actual  replace- 
ment requirements  from  year  to  year, — nothing  the 
first  year,  a  small  amount  the  second  year  and  increas- 
ing amounts  thereafter  until  a  time  is  reached  when 
the  replacement  requirements  will  be  approximately 
those  estimated  by  the  straight  line  method.  This 
method  has  the  advantage  of  simplicity.  It  is  the 
method  adopted  on  public  works,  such  as  streets 
sewers,  public  buildings,  harbors  and  generally  all 
public  non-revenue  producing  properties.  It  is  the 
common  sense  method. 

Under  neither  of  these  methods,  if  properly  ap- 
plied, and  if  the  replacement  fund  is  actually  created  in 
proper  amount  out  of  earnings,  will  there  have  been 
any  retirement  of  capital.  The  rate-base  in  each  case 
will  be  original  investment  undiminished  by  accrued 
depreciation. 


GENERAL     COMMENTS  13 

When  the  utility  to  be  brought  under  regulation 
is  no  longer  new ;  when  it  represents  a  plant  which 
has  seen  long  service,  but  which  is  at  full  efficiency 
when  gauged  by  its  own  standard  and  falls  into  that 
class  for  which  it  should  be  assumed  that  past  earn- 
ings have  not  retired  any  of  the  investment,  the  first 
inquiry  will  be  as  to  whether  or  not  there  has  been 
established  out  of  earnings  any  replacements  fund.  If 
there  be  none,  then  the  actual  current  replacement  re- 
quirement will  be  the  proper  allowance.  This  will  have 
to  be  estimated  perhaps  by  the  straight  line  method, 
corrected  by  practical  experience.  If  the  estimate  be 
at  fault  no  harm  will  be  done  as  there  will  be  a  sepa- 
rate accounting  for  the  money  which  goes  into  the 
fund  and  if  the  same  is  either  depleted  or  grows  too 
fast,  suitable  correction  can  readily  be  made  in  the 
future  replacement  allowances.  When  there  is  a  fund, 
the  earnings  of  which  are  retained  therein,  then  the 
fund  earnings  will  reduce  the  replaceement  increment 
which  is  to  be  collected  from  the  rate-payer. 

Accrued  Depreciation  Non-Essential  in  Rate 
Fixing 

It  will  be  seen  from  the  foregoing  that  the  vast 
amount  of  work  which  has  been  clone  in  recent  years 
to  ascertain  accrued  depreciation  as  an  element  for 
consideration  in  regulating  the  rates  of  railroads  and 
other  public  utilities  is  wasted  energy.  The  require- 
ment apparently  laid  down  by  the  courts  that  value 
must  be  made  a  starting  point  has  led  experts  and 
valuation  commissions  to  seek  new  meanings  in  the 
world  value.  The  writer  hopes  that  some  day  the 
supreme  court  will  so  interpret  or  modify  its  Knox- 
ville  decision  that  the  public  service  commission  will 
feel  free  to  cut  loose  from  value  when  fixing  upon 
a  rate-base.  He  has  faith  in  the  valuation  experts  and 
economists  but  believes  that  they  should  press  with 
greater  vigor  the  demand  for  a  simplified  procedure. 
It  is  their  duty  to  enlighten  the  courts.  They  should 
have  the  courage  to  point  out  any  correct  proceeding 
even  though  in  conflict,  at  least  apparently  so.  with 
the  decisions  of  the  courts,  because  anv  conclusion  of 


14  PUBLIC     UTILITY    RATE     FIXING 

the  (court  as  expressed  Sn  ithe  Knoocville  decision 
remains  binding  only  until  the  same  has  been  modi- 
fied by  a  later  finding  of  the  same  high  authority. 
Until  this  is  done,  however,  the  valuation  engineer 
will  find  it  advisable  to  comply  with  the  requirements 
of  the  public  service  commissions,  and  to  struggle 
with  "present"  and  "market  value"  and  let  the  commis- 
sions and  the  courts  make  the  most  of  a  bad  sit- 
uation. Now  and  then  he  may  find  a  court  which  is 
bold  enough  to  say  that  accrued  depreciation  may  be 
ignored  as  in  Idaho  where,  in  the  Pocatello  Water 
Company  case  the  Supreme  Court  of  the  state  re- 
cently, said': 

"So  far  as  the  question  of  depreciation  is  concerned,  we 
thinlT'deduction  should  be  made  only  for  actual  tangible  de- 
preciation and  not  for  theoretical  depreciation,  sometimes 
called  'accrued  depreciation.'  In  other  words,  if  it  be  demon- 
strated that  the  plant  is  in  good  operating  condition  and  giv- 
ing as  good  service  as  a  new  plant,  then  the  question  of 
depreciation  may  be  entirely  disregarded." 

The  Bonus  and  the  Rate  Base 

The  question  is  sometimes  asked,  "How  does  a 
bonus  affect  the  rate-base?"  The  answer  to  this  ques- 
tion should  be  given  with  due  regard  to  all  circum- 
stances. Thus  for  example,  if  the  owner  is  given  a 
bonus  to  build  a  steamboat  equal  to  the  entire  cost  of 
the  steamboat  and  the  earnings  are  such  that  within 
the  life  of  the  boat  there  will  be  a  surplus,  above  op- 
erating cost  plus  compensation  to  the  owner  for  man- 
agement, such  that  this  surplus  will  build  a  new  steam- 
boat, the  owner  will  have  at  no  time  made  any  invest- 
ment and  it  may  be  proper  to  use  a  rate-base  without 
inclusion  of  the  steamboat.  If,  however,  the  earnings 
have  yielded  only  a  moderate  excess  over  operating  ex- 
penses and  no  fund  has  been,  nor  could  have  been 
created  out  of  surplus  earnings  from  which  to  pay  for 
the  renewal  of  the  steamboat,  then  the  new  steamboat 
will  have  to  be  constructed  with  funds  borrowed  or  at 
any  rate  contributed  by  the  owner.  The  original  bonus 
will  have  disappeared  as  a  business  loss  and  the  cost 
of  the  new  steamer  will  be  included  in  the  rate-base. 


GENERAL     COMMENTS  15 

Or,  as  another  illustration,  in  the  interest  of  some  local 
project  as,  for  example,  the  development  of  a  coal  mine 
a  line  of  railroad  is  built  which  is  then  turned  over  as 
a  gift,  subject  to  the  condition  that  it  be  operated,  to 
some  larger  railway  system.  The  new  owner  of  the 
railroad  in  this  case  has  made  no  investment.  The  coal 
road  may  not  pay.  Perhaps  its  earnings  will  just  off- 
set operating  expenses  including  a  proper  allowance 
for  replacement  (depreciation).  The  new  owner  has 
made  no  sacrifice  to  acquire  the  coal  road.  Its  cost 
need  not  be  included  in  the  rate-base  unless  the  ad- 
dition of  the  road  as  a  profit  allowance  is  justified  by 
circumstances.  In  most  cases  in  practice  the  latter 
will  be  proper  and  ordinarily  when  long  established 
systems  and  long  past  transactions  are  under  review 
no  other  course  would  be  allowed.  The  situation  is 
similar  when  a  tract  of  land  is  laid  out  in  town  lots 
and  the  streets  are  improved  and  water  and  gas  mains 
are  laid  and  these  mains  are  then  donated  to  the 
established  water  and  gas  companies  with  no  condi- 
tion other  than  that  water  and  gas  be  supplied  to 
those  who  locate  upon  the  tract.  Here  again  the  own- 
ers of  the  water  and  gas  works  enter  into  obligations 
to  operate  and  maintain  the  additions  to  their  systems, 
but  they  have  made  no  sacrifice  to  secure  these  addi- 
tions which  in  the  end  will  be  paid  for  by  the  pur- 
chasers of  the  lots  in  the  subdivided  area.  Conse- 
quently these  additions  should  not  appear  in  the  rate- 
base,  at  least  not  at  full  cost  until  the  demand  upon 
them  is  so  large  that  their  inclusion  will  not  be  a  bur- 
den upon  the  rest  of  the  system.  "Whenever  included, 
unless  they  have  been  operated  at  a  loss  (receipts 
less  than  operating  expenses),  their  inclusion  will  be 
equivalent  to  a  profit  allowance  to  their  owners.  Good 
practice  would  be  to  give  preference  to  the  inclusion 
of  such  donations  except  when  they  are  of  recent  date 
or  when  other  circumstancs  warrant  a  special  investi- 
gation to  determine  the  course  of  action. 


16  PUBLIC    UTILITY    RATE     FIXING 

Cost  and  Value  of  Water  Rights  in  Their  Relation 
the  Rate  Base 

That  a  water-right  has  value  is  now  a  generally 
recognized  fact.  When  water  is  used  for  irrigation  it 
assists  in  producing  a  crop  which  can  be  put  on  the 
market  at  prices  not  subject  to  regulation.  The  water 
delivered  at  the  irrigated  farm  has  a  value  deter- 
minable  from  the  profit  which  it  enables  the  farmer 
to  make  by  increasing  the  crop  output  of  his  soil.  The 
water  in  the  stream  from  which  the  canal  system  ob- 
tains its  water  for  delivery  to  the  farmer,  has  greater 
or  less  value  according  to  many  modifying  factors  such 
as  the  character  and  value  of  the  crop  irrigated ;  the 
amount  of  water  required  to  produce  the  crop ;  the  cost 
of  the  canal  system  in  relation  to  the  acreage  served; 
the  quality  of  the  water ;  the  availability  of  alternative 
sources  of  supply ;  the  limit  of  the  supply  in  the  avail- 
able sources  in  comparison  with  the  area  of  irrigable 
lands ;  the  cost  of  preparing  the  land  for  irrigation ; 
and  the  prospective  demand  upon  the  source  of  supply 
for  higher  uses  of  the  water.  The  riparian  right,  too, 
has  value  not  alone  because  the  water  is  in  the  stream 
at  the  border  of  the  land  but  also  because  under  the 
doctrine  of  riparian  rights  the  land  owner  has  a  lim- 
ited right  to  use  the  water.  Consequently  when  there 
is  any  new  development  involving  the  utilization  of 
water  the  adjustment  with  the  owners  of  prior  rights 
may  involve  an  outlay.  In  any  well  settled  region, 
the  cases  will  be  rare  in  which  water  can  be  had  with- 
out cost.  Any  legitimate  expenditure  for  water  rights 
by  the  owner  of  a  public  utility  is  to  be  made  a  part 
of  the  rate-base.  Whenever,  therefore,  the  time  has 
come  when  the  use  of  the  water  is  a  necessity  and  there 
is  no  cheaper  alternative  source  of  supply,  a  strategic 
value  may  result  as  in  the  case  of  rates  which  were 
determined  by  the  less  favorable  situation  of  some 
other  concern  operating  in  the  same  territory.  On  this 
subject  the  following  is  taken  from  "Valuation,  Depre- 
ciation and  the  Rate-Base,"  page  216: 

"As  an  illustration  of  special  water-right  value  the  case 
of  a  water  supply  for  general  and  domestic  use  which  affords 


GENERAL    COMMENTS  17 

water  of  prime  quality  in  limited  amount  may  be  taken,  but 
which,  when  compared  with  other  sources  in  use  in  the  same 
community,  has  the  advantage  of  proximity,  elevation  and 
reliability  of  service. 

"Let  it  be  assumed  for  example,  that  such  a  supply 
was  the  first  to  come  into  use,  that  its  water  was  distrib- 
uted as  required  throughout  the  built-up  section  of  a  growing 
town,  but  that  at  length  a  time  came  when  additional  water 
had  to  be  brought  in  by  a  second  system  from  some  remote 
source,  and  that  at  the  time  of  the  valuation  the  distrib- 
uting pipes  of  each  of  the  two  systems  cover  practically  the 
entire  built-up  territory.  The  original  water-works  may  now 
be  supplying  only  a  small  fraction  of  the  aggregate  amount 
of  water  being  used.  Undoubtedly  under  such  circumstances, 
the  charge  for  water  by  the  two  concerns  would  be  the  same 
or  very  nearly  the  same.  The  water  from  the  newer  works 
could  not  be  supplied  at  a  low  enough  rate  to  drive  the 
earlier  concern  out  of  business.  Without  any  reduction  of 
rates,  this  original  utility  should  hold  its  customers.  There 
need  be  no  falling  off  in  the  amount  of  water  which  it  sup- 
plies, assumed  to  be  the  limit  of  its  capacity.  But,  if,  as 
assumed,  the  rates  charged  by  the  two  concerns  are  the  same, 
the  relative  amount  of  net  earnings  will  be  greater  for  the 
original  than  for  the  new  water-works.  If  it  costs  the  orig- 
inal concern  17.5  cents  per  thousand  gallons  to  develop  and 
market  its  water  crop  (interest  on  the  investment  included) 
and  it  is  costing  the  new  concern  20  cents  to  do  the  same, 
and  if  this  larger  cost  has  been  taken  into  account  in  fixing 
the  water  rates,  then  the  water-right  and  other  intangible 
elements  of  value  of  the  original  concern  may  reasonably  be 
valued  at  ($200-$175)  $25,  per  day  per  million  gallons  of 
daily  delivery  more  than  the  water-right,  and  other  intangi- 
ble elements  of  value  of  the  new  concern.  This  is  interest  on 
about  $150,000,  if  6  per  cent  per  annum  be  made  the  basis 
of  the  calculation. 

"If,  in  other  words,  rates  are  allowed  which  in  the  case 
of  the  new  or  main  water-works  system  will  create  a  water- 
right  value  of  $50,000  per  million  gallons  of  daily  delivery 
for  the  new  water-works,  then  the  value  of  the  water-rights 
controlled  by  the  original  system  may  be  about  $200,000  per 
million  gallons  per  day." 

How  to  determine  the  value  of  a  water-right  is  a 
question  which  has  not  yet  been  satisfactorily  an- 
swered. There  is  no  general  market  for  water-rights. 


18  PUBLIC     UTILITY    RATE     FIXING 

Their  beneficial  use  is  restricted  to  limited  areas  and 
to  certain  purposes  such  as  the  generation  of  power, 
irrigation  and  domestic  use.  It  is  not  possible  to  go 
into  the  market  at  any  time  and  to  secure  a  bid  for  a 
water-right.  Nevertheless  there  are  cases  in  which 
a  determination,  at  least  of  an  upper  or  lower  limit  of 
value,  can  be  made.  The  city  of  Sacramento,  for  ex- 
ample, draws  its  water  direct  from  Sacramento  River. 
The  low  water  flow  of  the  river  at  Sacramento  is  about 
5000  cubic  feet  per  second.  The  demand  of  the  city 
upon  the  river  in  comparison  with  this  volume  is  so 
small  as  to  be  almost  negligible.  The  abstraction  of 
the  city  water  is  no  damage  to  navigation  interests  nor 
to  the  rights  of  riparian  owners.  The  state  has  not 
exacted  any  payment  for  the  privilege  of  taking  the 
water.  The  water-right  has  only  nominal  value 
although  the  water  is  applied  to  the  highest  possible 
type  of  use. 

In  contrast  with  such  a  situation,  there  is  the 
water  power  right  controlled  by  riparian  ownership  in 
a  region  where  the  demand  for  power  is  such  that  the 
desirability  of  utilizing  the  water  power  is  unques- 
tioned. The  value  of  the  power  right  in  such  circum- 
stances is  determinable  from  the  market  value  of 
power  as  established  by  the  use  of  oil  or  coal,  as  the 
case  may  be,  provided  always  that  the  water  power 
is  not  of  such  magnitude  as  to  completely  crowd  coal 
and  oil  out  of  the  field.  In  the  event  that  this  happens 
the  steam  plant  can  do  no  more  than  determine  an 
upper  limit  of  the  value  of  the  water-power. 

Conditions  may  be  such  that  at  current  prices  of 
fuel  the  cost  of  developing  power  is  less  with  steam 
than  with  water  in  which  event  the  wisdom  of  the 
water  power  development  may  be  called  in  question. 
But  in  view  of  the  advantage  to  society  of  bringing 
all  water  powers  into  use  so  as  to  conserve  the  con- 
sumption of  the  oil  and  coal,  whose  supply  is  limited, 
the  case  will  be  rare  in  which  the  owner  should 
be  denied  a  reward  for  having  gone  into  the  power 
business  as  he  might  be  in  case  that  no  profit  is 
allowed,  the  absence  of  which  would  eliminate  all  in- 


GENERAL     COMMENTS  19 

tangible  values,  including  the  water  right.  When  such 
a  case  is  presented  liberal  treatment  may  be  expected 
and  even  demanded  as  a  reward  for  the  conservation 
of  power  that  otherwise  would  be  lost.  The  owner, 
even  in  such  cases,  is  entitled  to  share  in  the  benefit 
which  he  confers  upon  society. 

Appreciation  in  Relation  to  the  Rate  Base 

Shall  appreciation  be  allowed  to  the  public  utility 
and  if  so,  how?  Yes,  but  within  limits.  If  instead  of 
owning  the  properties  whose  value  increases  with  age, 
such  as  real  estate,  these  properties  were  leased  from 
outside  owners,  the  demand  by  such  outside  owners 
would  be  for  rentals  increasing  with  the  increasing 
value.  The  increasing  value  may,  therefore,  be  allowed, 
but  if  allowed  it  is  a  part  of  the  aggregate  profit  which 
should  go  to  the  owner  as  already  explained,  to  permit 
him  to  participate  in  the  general  prosperity  of  the 
community,  which  is  reflected  in  the  appreciation,  and 
to  compensate  him  for  management  and  business  haz- 
ards. As  the  appreciation  of  real  estate  is  not  reg- 
ular and  cannot  be  forecast  with  any  great  degree  of 
precision,  and  as  the  appreciation  in  certain  cases  in 
the  past  has  been  beyond  any  equitable  allowance  of 
profit,  it  is  more  logical  after  regulation  of  rates  has 
commenced  and  a  proper  rate  base  has  been  once 
established,  to  treat  appreciating  property  as  having 
been  dedicated  to  public  use  at  its  cost  or,  in  some 
cases,  at  the  estimated  cost  of  reproduction  when  the 
initial  valuation  for  rate  regulation  purposes  is  made, 
always  conditioned  upon  the  payment  by  the  public 
of  a  reasonable  amount  for  such  use,  and  thereafter  to 
let  the  general  profit  allowance  include  something  for 
current  appreciation,  thus  covering  the  owner's  share 
in  the  general  prosperity  and  protecting  the  rate- 
payer's participation  in  the  utility's  unearned  incre- 
ment. Under  this  system  even  the  utility  which  does 
not  own  real  estate  or  other  appreciating  property 
would  also  get  a  fair  share  of  the  unearned  increment. 
It  should  be  remembered,  in  this  connection,  that  the 
value  of  money  is  constantly  dropping.  The  rise  in 


20  PUBLIC     UTILITY    RATE     FIXING 

the  value  of  real  estate  is,  therefore,  not  entirely  due 
to  the  demand  of  society  that  it  be  used  for  higher  pur- 
poses. This  rise  is  in  part  due  to  the  fact  that  as  time 
goes  on  the  same  amount  of  money  will  purchase  a 
smaller  amount  of  service  or  of  the  necessities  and 
conveniences  that  make  life  possible  and  worth  while. 
It  is  the  function  of  the  profit  allowance  to  meet  this 
hazard  among  the  others  which  would  in  part  be  cov- 
ered by  appreciation  for  the  utility  rich  in  real-estate, 
but  to  which  other  utilities  which  own  no  realty  are 
also  entitled.  Herein  will  be  seen  good  reason  for 
adopting  the  writer's  suggestion  of  bringing  the  profit 
allowance  into  a  fair  relation  to  the  volume  of  business. 

Illustrations  Showing  Practical  Application  of  Some 
Fundamental  Principles 

To  illustrate  some  of  the  fundamental  principles  in 
their  practical  application,  a  railroad  property  may  be 
brought  under  consideration  which  has  been  long  in 
operation.  By  an  examination  of  book  records  and  a 
physical  valuation  it  has  been  determined  that  the 
legitimate  original  cost  of  the  railroad  may  be  taken  at 
$20,000,000  and  that  ordinary  operating  expenses  are 
$2,000,000  and  the  average  annual  expenditures  for 
replacements  are  $500,000  per  year.  In  making  an  ap- 
praisal of  value  in  conformity  with  the  requirements 
of  the  Interstate  Commerce  Commission,  it  is  found 
that  the  accrued  depreciation  of  physical  properties  is 
$4,000,000.  The  appreciation  in  this  case  and  the  cost 
of  developing  the  business  are  assumed  to  be  in- 
cluded, so  far  as  allowable,  in  the  $20,000,000.  The 
bonds  of  the  road  are  6  per  cent  and  a  fair  allowance 
for  discounts  and  commissions  shows  that  7  per  cent 
would  be  a  fair  net  rate  of  interest  on  borrowed  money 
free  from  any  profit  increment. 

Under  the  proceedings  as  they  are  customary  the 
further  inquiry  would  relate  to  the  "going  value"  and 
to  the  proper  rate  of  return  on  the  fair  value  of  the 
property.  Suppose  the  going  value  is  allowed  at 
$2,000,000  and  that  8  per  cent  be  agreed  upon  as  a 
fair  rate  of  return. 


GENERAL    COMMENTS  21 

According  to  the  usual  custom  the  allowable  earn- 
ings would  be  found  as  follows: 

Coat  new  - $20,000.000 

Accrued    depreciation 4,000,000 

Cost    new    legs    depreciation $16,000,000 

Going    value    2,000,000 

The  present  or  fair  value $18,000,000 

Required    Earnings — 

Operating    expenses    $2,000,000 

Replacement    allowance    (depreciation) 600,000 

Return  allowance  8   per   cent   on   $18,000,000 1,440,000 

Required    earnings    ..._ $3,940,000 

Besides  this  there  will  be  some  more  or  less 
definite  amount  of  appreciation  which  does  not  lend 
itself  to  inclusion  in  such  figures  as  these. 

According  to  the  alternative  plan  under  which 
accrued  depreciation  is  ignored,  as  of  no  effect  upon 
the  rates : 

Rate-base,   original    investment $20,000,000 

Required  Earnings — 

Operating   expenses    ™ ............... ._ ~     $2,000,000 

Replacement    allowance    ~ 500,000 

Interest  7   per  cent  on  $20,000,000 1,400,000 

Profit  allowance  10  per  cent  of  the  annual  income  about 400,000 


$4,300,000 

Either  there  must  be  considerable  property  in  the 
possession  of  and  in  use  by  the  railroad  company  of 
the  type,  which  is  increasing  in  value ;  or,  under  the 
first  procedure,  the  allowed  rate  of  return,  8  per  cent, 
is  too  small ;  or,  the  allowance  for  going  value  is  too 
small.  If  the  last  suggestion  were  the  correct  one  and 
not  supplemented  by  other  factors,  then  "going  value" 
should  be  increased  to  about  $7,000,000  instead  of  the 
$2,000,000  introduced  into  the  calculation.  If  the  cor- 
rection is  to  be  made  in  the  rate  of  return  this  would 
have  to  be  allowed  at  about  10  per  cent  instead  of  at 
8  per  cent. 

The  advantage  of  bringing  the  profit  allowance 
into  a  fair  relation  to  the  volume  of  business  is 
best  apparent  in  the  case  of  a  utility  which  does  a 
large  amount  of  business  on  a  small  investment.  Sup- 
pose that  an  express  company  has  invested  $1,000,000 
and  that  its  gross  annual  income  for  several  years, 
has  been  about  $4,000,000.  If  the  accrued  depreciation 


22  PUBLIC     UTILITY    RATE     FIXING 

is  $250,000  the  ordinary  procedure  might  be  about  as 
follows : 

Present  fair  value  of  physical   elements,   etc. — 

Estimated    cost    new    $1,000,000 

Accrued    depreciation    250,000 


Cost   new   less   depreciation „ $    750,000 

Going  value  possibly   2,000,000 


Fair  value  $2,750,000 

Required  Earnings — 

Operating    expenses $3,400,000 

Replacement  allowance   100,000 

Return  allowance  17%  on  $2,750,000 480,000 


Total   $3,980,000 

It  will  be  noted  that  the  reurn  rate  is  introduced 
into  the  calculation  fairly  high,  because  the  invest- 
ment is  small  and  the  courage  is  lacking  to  make  the 
intangibles  appear  in  the  rate-base  at  $5,000,000,  or 
more,  as  they  probably  would  be  rated  by  a  purchaser 
if  the  business  is  a  monopoly. 

Under  the  alternative  plan  the  accrued  deprecia- 
tion would  again  be  ignored  and  the  profit  allowance 
would,  perhaps,  be  about  10  per  cent  on  the  volume 
of  business: 

Rate-base,  the  original   investment $1,000,000 

Required    Earnings — 

Operating    expenses    $3,400,000 

Replacement   allowance   100,000 

Interest  7   per  cent  on   $1,000,000 70,000 

Profit  allowance  10  per  cent  on  $4,000,000 400,000 


Total    $3,970,000 

When  all  the  capital  is  invested  in  a  single  depre- 
ciating item,  as  in  the  case  of  a  steamboat,  as  already 
described  the  first  step  of  the  usual  practice  is  to  find 
the  steamboat's  remaining  value,  a  value  which 
changes  from  year  to  year.  Suppose  that  the  steam- 
boat has  cost  $250,000;  that  it  is  found  upon  examina- 
tion that  it  should  serve  about  five  years  longer;  that 
a  steamboat  of  its  type  has  a  probable  life  when  new  of 
20  years,  and  that  the  amount  of  business  (gross 
income)  has  been  about  $500,000  per  annum. 

In  this  case  the  remaining  value  of  the  steamboat 
would  be  determined  by  the  sinking  fund  method  and 
for  a  remaining  life  of  5  years  in  a  20-year  life  table  at 
7  per  cent  would  be  found  to  be  $97,000.  Assuming 


GENERAL     COMMENTS  23 

the  steamboat  business  to  be  a  monopoly  there  would 
be  something  added  for  going  value,  perhaps  as  much 
as  a  new  steamboat  would  cost  or  $250,000. 

The  required  earnings   would  be — 

Operating   expenses - - $400,000 

Replacement   or   depreciation   allowance   by   the   compound    inter- 
est   method ;    the    amount    which    will    retire    the    remaining 

value  in  6  years,  7   per  cent  interest 17,300 

Return   allowance   20    %   on    ($97,000  +  $250,000) 69,400 

Total  - $486,700 

While  the  question  whether  or  not  the  earnings  in 
the  past  have  actually  been  sufficient  to  yield  inter- 
est on  the  investment  from  the  beginning  plus  the 
increment  supposed  to  have  been  applied  from  year 
to  year  to  retire  capital  will  be  a  proper  one,  the  large 
allowance  of  intangible  value  covers  any  possible  past 
deficiency.  This  large  allowance  results  from  the 
consideration,  it  is  assumed,  of  all  the  circumstances 
such  as  hazard,  fluctuation  in  the  annual  volume  of 
business  and  the  like. 

Under  the  simpler  alternative  procedure  the  orig- 
inal investment,  $250,000  would  be  the  rate  base  and 
the  required  earnings  would  be  estimated  as  follows : 

Required    Earnings — • 

Operating     expenses     _ $400,000 

Replacement    allowance    sinking    fund    method    20    year    life    1%         6,100 

Interest  7   per  cent  on   $250,000 17,500 

Profit  allowance  about  12  per  cent  of  $500,000 60,000 


Total   $483,600 

If  water-works  are  under  consideration  the  cir- 
cumstances may  be  about  as  follows :  The  water- 
works have  been  long  in  service.  They  were  originally 
built  by  a  group  of  public  spirited  citizens  and  oper- 
ated at  a  loss.  This  loss  may  or  may  not  have  been 
a  willing  sacrifice  offset  by  the  growing  value  of 
the  real  estate  in  the  individual  possession  of  the 
owners.  As  the  community  grew,  the  water-works 
grew.  The  original  source  of  supply  may  have  been 
wells  which  had  to  be  abandoned  after  a  time  because 
contamination  rendered  the  water  unfit  for  domestic 
use.  Other  near-by  sources  were  brought  into  use, 
some  retained  and  others  abandoned.  The  system,  as 
now  in  use,  commands  a  supply  of  good  water  ade- 
quate in  quantity  for  some  20  years,  with  other  sources 


24  PUBLIC     UTILITY     RATE     FIXING 

in  sight  that  can  be  developed  at  an  increasing  unit 
cost.  There  has  been  no  satisfactory  regulation  of 
rates  in  the  past.  The  original  owners  have  passed 
out  of  consideration  and  the  stock  of  the  corpora- 
tion now  owning  the  property  is  in  the  hands  of  many 
people,  some  of  whom  have  acquired  it  within  the 
last  year  or  two.  The  bonds  which  are  outstanding, — 
about  $7,000,000 — bear  interest  at  6  per  cent  and  are 
worth  95  per  cent.  There  is  no  alternative  supply 
having  advantages  equal  to  the  developed  and  pros- 
pective sources.  There  has  been  no  payment  for  fran- 
chises. The  acquisition  of  certain  water-rights  repre- 
senting one-fourth  of  the  supply  has  cost  the  company 
$200,000.  These  water-rights  were  acquired  10  years 
ago. 

In  this  instance  the  books  show  the  cost  of  construc- 
tion during  the  recent  years  and  the  cost  of  the  acqui- 
sition of  some  of  the  lands  and  rights-of-way,-  but 
there  is  no  information  available  relating  to  the  actual 
investment  covering  the  entire  period  of  operation  nor 
yet  relating  to  whether  the  earnings  fully  amortized 
the  capital  which  had  been  invested  in  the  property 
abandoned  from  time  to  time.  An  investigation  is 
therefore  made  to  verify  and  to  supplement  the  records 
of  cost  and  it  is  found  that,  including  the  cost  of  rights- 
of-way  and  the  actual  cost  of  water  rights,  whether 
taken  from  records  or  approximated,  the  total  actual 
legitimate  capital  investment  as  of  the  date  of  the 
proposed  rate  regulation  is  $10,000,000.  In  this  ap- 
praisal, market  value  of  real  estate  is  included  when 
its  acquisition  was  not  recent  and  does  not  appear 
in  the  records.  Cost  and  an  allowance  for  the  increase 
of  value  may  in  many  cases  be  a  good  guide  in  deter- 
mining at  what  value  it  should  be  introduced  as  a 
part  of  the  invested  capital.  In  this  valuation  of  $10,-, 
000,000  there  are  included  all  properties  in  use  and 
those  held  for  use  within  a  rather  indefinite  period 
of  some  20  to  25  years  in  the  future. 

If  the  value  of  physical  elements  and  the  value  of 
the  intangibles  must  be  taken  into  account,  as  the 
courts  and  many  of  the  rate  regulating  commissions 


GENERAL    COMMENTS  25 

seem  to  require,  it  now  becomes  necessary  to  approxi- 
mate the  accrued  depreciation  of  the  physical  elements. 
This  is  done  by  approximating  for  each  class  of  items 
or  for  each  item  which  is  of  sufficient  importance  to 
be  individualized,  its  remaining  term  of  usefulness 
or  expectancy  and  from  depreciation  tables  for  the 
probable  life  term  new  of  each  class  and  this  life 
expectancy,  the  accrued  depreciation  and  the  remaining 
value  are  found.  This  tedious,  difficult  and  unsatis- 
factory proceeding  shows  for  these  water-works  that 
the  accrued  depreciation  is  $2,000,000. 

Going  value  is  now  to  be  appraised.  For  this  there 
is  absolutely  no  basis  because  it  results  from  the  in- 
crement of  earnings  which  is  left  after  deducting  oper- 
ating expenses,  current  depreciation  or,  rather,  re- 
placement requirements,  and  interest  on  the  invest- 
ment. The  best  judgment  of  experts  is  called  in,  and 
their  chief  aim  will  be  to  at  least  offset  the  accrued 
depreciation.  The  result  is  an  allowance  of  about 
$2,500,000  for  going  value. 

Now  conies  the  question  of  water  rights.  One- 
fourth  of  the  water  in  use  has  actually  cost  $200,000 
and  this  amount  is  included  in  the  $10,000,000  of  in- 
vestment. If  one-fourth  of  the  water  cost  $200,000 
and  the  remainder  is  equally  valuable  there  should 
appear  in  the  "value,"  if  itemized,  an  additional  $600,- 
000  for  water  rights  and  perhaps  more,  because  the 
basis  of  this  calculation  is  a  value  which  obtained 
10  years  ago. 

The  most  common  practice  of  the  day  would, 
therefore,  start  with  a  valuation,  being  the  present 
or  fair  value  as  follows : 

Physical    elements    and    actual    cost    of    rights-of-way 
and    of    water    rights,    less    accrued    depreciation 

$10,000,000  —  $2,000,000  $8,000,000 

Water   rights,   value   in   addition   to   cost 600,000 

Going  value    2,500,000 


Present   value    $11,100,000 

It  being  assumed  that  this  enterprise  is  in  every 
way  legitimate  and  well  managed,  the  value  of  the 
outstanding  bonds  and  their  rate  of  interest  can  be 
used  as  a  guide  to  determine  what  the  rate  of  return 
should  be  on  this  valuation. 


26  PUBLIC     UTILITY    RATE     FIXING 

At  95  per  cent  the  6  per  cent  bonds  net  6.3  per 
cent.  The  cost  of  marketing  the  bonds  was  probably 
at  least  1  per  cent.  It  is  likely,  furthermore,  that  at 
the  time  the  bonds  were  issued  the  amount  realized 
was  less  than  95  per  cent.  It  is  concluded  from  such 
facts  as  these  that  the  cost  of  money  for  this  enter- 
prise should  be  taken  at  7  per  cent  and  that  of  the  rate 
of  return  on  the  value  of  the  water-works  should  be  8 
per  cent. 

Investigation  has  also  been  made  of  the  cost  of 
operation  and  it  is  found  that 

Ordinary  average  annual  operating  cost  including  main- 
tenance and  repairs  is $400,000 

The  average  annual  replacement  requirement  based  on 

actual  experience  is 200,000 

The  estimated  current  depreciation  by  sinking  fund 
methods  which  should  have  been  earned  from  the 
beginning  is  found  to  be 64,000 

In  determining  the  required  earnings  what  allow- 
ance shall  be  made  for  current  depreciation?  This 
must  be  settled  by  those  using  this  procedure  with 
due  consideration  to  the  facts  in  each  case.  There 
is  no  depreciation  or  replacement  fund  in  this  case, 
consequently  there  is  no  interest  on  such  a  fund  to 
supplement  the  estimated  current  depreciation.  The 
earnings  must  cover  the  annual  replacement  require- 
ments which  are  best  determined  by  actual  experi- 
ence but  which  can  also  be  approximated  by  well 
known  methods  of  procedure.  Using  the  result  of 
actual  experience  in  this  case  the  required  earnings 
are  now  estimated  as  follows  : 

Required  Earnings — 

Operating  expenses    I     400,000 

Replacement  or  depreciation  allowance  ordinarily  esti- 
mated  but   in   this  case   determinable   from   actual 

experience  at 200,000 

Return  allowance  S  per  cent  on  $11,100,000 888,000 


$1,488,000 

The    application    of    the    simple    alternative    pro- 
cedure in  this  case  is  as  follows  : 

The  rate-base  is  the  legitimate  investment,  $10,000,000. 

Required   Earnings — 

Operating  expensf-s    $  400,000 

Interest  1  per  cent  on    $10,000,000 700.000 

Replacement  requirement   200,000 

Profit    allowance    12    per    cent    of    $1,500,000      (approx. 

gross  income)    180,000 

$1,480,000 


GENERAL     COMMENTS  27 

Investment  as  a  Rate  Base  Contrasted  with  Value 

The  one  procedure  is  logical  throughout.  The 
other  is  not.  In  the  alternative  the  going  value  and 
the  water-right  value  are  fully  covered  in  the  capi- 
talized profit  allowance.  In  connection  with  the  rate- 
fixing  proceeding  there  is  no  need  of  separating  these 
intangibles  nor  even  of  inquiring  whether  if  aban- 
doned by  the  utility  the  water  right  might  not  have 
a  higher  value  than  a  fair  division  of  the  profit  allow- 
ance would  give  it.  The  full  protection  of  the  invest- 
ment is  secured  and  the  rate-payer  is  given  the  sat- 
isfaction of  knowing  that  there  is  a  limit  set  to  the 
profit  which  the  owner  of  the  utility  may  make  in 
the  future.  Once  the  basic  valuation  has  been  made, 
as  above  set  forth,  the  appreciation  of  real-estate  and 
other  items  would  be  covered  in  the  profit  allowance. 
Additional  appreciation  would  not  again  be  carried  into 
the  rate-base,  but  if  appreciating  property  were  at  any 
time  in  the  future  released  from  further  public  service, 
its  full  value,  including  all  appreciation,  would  go  to 
the  owner  at  that  time. 

The  valuations  thus  far  required  by  all  rate-fixing 
authorities  have  been  made  with  careful  attention^ 
to  the  smallest  details.  A  standard  has  been  set  for 
the  approximation  of  the  cost  of  reproduction  of  the 
plant,  to  be  valued,  which  would  be  commendable, 
except  for  the  fact  that  the  careful  estimate  of  phys- 
ical value  is  at  once  supplemented  by  the  crudest  kind 
of  an  approximation  of  intangible  values.  No  basis 
has  been  established  or  found  of  determining  the  prin- 
cipal intangible  item  "going  value"  and  yet  an  arbi- 
trary allowance  for  the  same,  always  crudely  approx- 
imate and  at  times  amounting  to  or  even  exceeding 
the  value  of  the  physical  elements,  is  added  and  given 
rank  and  weight  with  the  latter.  The  sooner  such  a 
practice  can  be  modified  the  better. 

Interests  of  the  Owner,  the  Rate  Payer  and 
the  Public 

What  the  rate-payer  has  a  right  to  expect  may  be 
summarixed  as  follows: 


2$  PUBLIC     UTILITY     RATE     FIXING 

(a)  Good  service,  the  best  that  conditions  permit  at 
reasonable  rates. 

(b)  A  share  in  the  unearned  increment  when  general 
prosperity  gives  this  to  the  owner  of  the  utility  in 
too  large  a  measure. 

(c)  A  reasonable  share,  in  the  course  of  time,  in  the 
benefit  which  results  from  any  material  reduction 
in  operating  costs  due  to  the  introduction  of  in- 
ventions or  new  processes  which  the  owner's  good 
management  and  skill  have  shown  to  be  advan- 
tageous. 

(d)  A  contribution  by  the  general  public  toward  the 
maintenance  of  the  utility,  which  may  be  secured 
by  a  liberal  payment  for  service  rendered  for  com- 
modities furnished  to  the  public  or  to  public  insti- 
tutions or  which  may  be  secured  by  a  remission 
of  local  taxes  in  whole  or  in  part : 

What  the  owner  should  demand  is : 

(a)  Interest  on  the  capital  legitimately  invested. 

(b)  An    ample    allowance  for    replacements    and    re- 
newals. 

(c)  An  ample  allowance  for  operating  expenses. 

(d)  Amortization    of    capital   invested    in   abandoned 
property. 

(e)  Compensation  for  management  and  for  assuming 
business  hazards. 

(f)  A  share  in  the  general  prosperity  which  his  utility 
helps  to  create. 

(g)  In  the  special  case  of  a  limited  life  of  the  utility 
or  its  acquisition  by  the  public,  a  return  of    the 
invested  capital. 

(h)   That  amortization  of  the  invested  capital  be  not 
confounded  with  accrued  depreciation. 
What  both  the  rate-payer  and  the  owner  are  en- 
titled to  in  addition  to  the  above  and  what  both  should 
demand  is : 

The  introduction  of  a  method  of  procedure 
when  rates  are  to  be  regulated  which  will  not  re- 
quire an  array  of  valuation  experts,  to  pad  a  close 
estimate  of  physical  values  with  a  number  of  ar- 


GENERAL     COMMENTS  29 

bitrary  intangible  values,  but  which  on  its  face 

will  be  intelligible  and  fair  to  all  concerned. 

The  items  (e)  and  (f)  as  enumerated  under  the 
owner's  demands  can  best  be  met  as  already  explained 
by  making  an  adequate  minimum  profit  allowance 
based  on  the  annual  gross  income. 

If  the  rate-payers  are  few  and  a  reasonable  service 
rate  will  not  fully  compensate  the  owner,  then  he 
should  be  held  harmless  in  the  future  larger  returns. 

In  the  case  of  the  business  which  has  been  oper- 
ating without  regulation  and  which  is  to  be  brought 
under  regulation,  the  present  owners  should  not  be 
made  to  suffer  unnecessarily  for  the  mistakes  and  im- 
proper business  methods  of  their  predecessors. 

Once  the  determination  of  the  natural  rate-base 
has  been  made,  the  future  modifications  thereof  should 
be  from  the  book  records  which  should  be  such  as  to 
show  at  all  times  the  additional  capital  legitimately  in- 
vested, the  discarded  property  and  its  cost,  and  the 
condition  of  the  replacement  fund,  which  altter  should 
be  just  adequate  to  meet  the  regular  demands  upon  it 
for  replacements  or  renewals,  and,  if  desired,  also  the 
repairs  and  generally  unkeep  expenditures. 

The  bringing  of  accrued  depreciation  into  the 
calculation  as  though  it  represented  amortization  ol 
a  part  of  the  investment  is  absurd ;  it  leads  to  a  com- 
plex, unsatisfactory  procedure,  and  compels  the  use 
of  arbitrary  allowances  for  intangible  values  which 
should  have  no  place  in  a  rate-base.  All  methods  of 
procedure  which  take  account  of  the  accrued  deprecia- 
tion when  rates  are  to  be  regulated  should  be  definitely 
and  finally  proscribed,  and  eliminated  from  considera- 
tion. 

Difficulty  of  Ascertaining  Depreciation 

In  December,  1916,  a  special  committee  of  the 
American  Society  of  Civil  Engineers  rendered  a  report 
on  the  Valuation  of  Public  Utilities  in  which  they 
accepted  the  apparent  requirement  of  the  courts,  that 
value  be  ascertained  and  made  the  starting  point  when 
rates  are  to  be  fixed.  The  committee  strongly  advo- 
cates the  use  of  a  method  of  procedure  which  it  calls 


30  PUBLIC     UTILITY    RATE     FIXING 

the  compound  interest  method  in  distinction,  from 
what  to  many  others  has  appeared  as  the  more  log- 
ical, the  sinking  fund  method.  Under  the  compound 
interest  method  the  value,  of  the  physical  elements 
is  to  be  ascertained  from  time  to  time,  perhaps  from 
year  to  year,  by  deducting  accrued  depreciation,  and 
the  allowance  for  current  depreciation  of  each  indi- 
vidualized article  is  .to  be  a  gradually  increasing 
amount,  readily  computed  from  original  cost,  probable 
life  new  and  age.  The  committee  overlooked  some 
of  the  difficulties  of  applying  this  method  to  one  of 
which  attention  may  be  briefly  called.  This  is  apart 
from  the  fact  that  the  compound  interest  method  like 
any  other  method  which  pretends  to  start  with  value 
in  any  form,  is  illogical  and  should  be  condemned. 
The  committee  explains  how  the  current  depreciation, 
which  they  should  have  called  amortization  of  capital, 
can  be  computed  or  can  be  taken  from  tables  for  any 
year  of  the  life  of  an  article  whose  probable  life  new 
is  known.  But  the  committee  fails  to  point  out  how 
to  proceed  when  of  a  large  number  of  articles,  such 
as  locomotives,  some  fail  before  their  predicted  term 
of  usefulness  has  expired  and  others  survive  long 
beyond  this  term.  Neither  the  sinking  fund  method 
nor  the  compound  interest  method  takes  this  non- 
agreemcnt  into  account.  A  mathematical  solution 
has  not  been  attempted  by  the  advocates  of  these 
methods.  None  is  possible,  as  a  matter  of  fact,  until 
the  expectancies  at  various  ages  for  the  various  arti- 
cles under  consideration  shall  have  been  determined 
with  some  degree  of  accuracy.  The  probable  life  is 
merely  the  average  of  all  available  records  of  service. 
It  is  the  result  of  the  recorded  human  experience 
with  all  articles  of  any  class.  While  this  probable 
life  new  may  be  predicted  with  some  degree  of  con- 
fidence for  many  articles,  the  individual  articles  of 
any  class  will  depart  widely  from  the  term  of  life 
predicted  for  them  as  a  class.  The  probable  life  being 
a  mean  of  the  actual  terms  of  service  of  numerous  ar- 
ticles, there  will  be  among  these  articles  for  each  one 
which  fails  m  years  before  the  expiration  of  its  prob- 


GENERAL    COMMENTS  31 

able  term,  another  which  survives  m  years  beyond  this 

m 
term,  or  two  which  survive — years  beyond  the  term, 

2 
m 
or  three  which  survive — years  beyond  the  term,  and 

3 
so  on. 

Suppose  that  a  large  number  of  locomotives  of  a 
certain  type  are  under  consideration,  whose  probable 
life  new  has  been  correctly  estimated  at  20  years. 
For  each  locomotive  which  fails  and  is  discarded  10 
years  before  the  end  of  the  20th  year  after  it  went 
into  service  is  reached,  there  will  be  one  surviving 
to  the  end  of  the  30th  year  or  two  surviving  to  the 
end  of  the  25th  year  or  three  whose  average  service 
beyond  the  predicted  period  is  3.33  years  and  so  on. 

Introducing  7  per  cent  into  the  calculation  and 
following  the  ordinary  erroneous  practice,  the  depre- 
ciation (or  replacement)  allowance  for  the  first  year 
would  be  in  percentage  of  cost  for  four  locomotives : 

Replacement    requirement,    ordinary    allowance     (current 

depreciation)   1st  year  4  X  2-44  H-  4  =  2.44% 

Compare  this  with  the  following  illustration  of 
what  is  bound  to  take  place,  though  perhaps  not  at 
exactly  the  assumed  terms  of  actual  life  of  the  indi- 
vidual locomotives : 

If  two  locomotives  fail  at  10  years  and  the  other 
two  at  30  years,  the  allowance  for  replacement 
by  the  sinking  fund  or  compound  interest 
methods  of  computation  which  are  here  under 
discussion  would  be: 

2   failing-  at  10  years.      2  X  7.24  =:  14.48% 
2   failing  at  30  years.     2  X  1.06=    2.12 

Total,  required  allowance 16.60  -f-  4  =  4.15% 

If  o'ne  locomotive  fails  at  5  years,  one  at  15  years, 
and   two  at   30  years: 

1   failing  at     5  years 17.39% 

1  failing  at  15  years 3.98 

2  failing  at  30  years.      2  X  1.06  =r    2.12 


Total,    required    allowance.  ...  23.49  -=-  4  =  5.87% 

If   one   fails   at    5   years,    two   at    20    years   and   one 
at   35   years: 

1  falling  at     5  years 17.39% 

2  failing  at  20  years.      2  X  2.44=:    4.88 
1  failing  at  35  years .72 


Total,    required    allowance.  ...  22.99  -f-  4  =  5.75% 


32  PUBLIC     UTILITY    RATE     FIXING 

In  each  of  the  illustrative  cases  the  average 
actual  life  of  the  four  locomotives  will  have  conformed 
to  the  predicted  probable  life  of  20  years,  but  in  each 
case  the  allowance  which  should  be  made  to  amortize 
the  capital  which  goes  out  of  use  with  the  locomotives 
is  larger  than  that  which  is  predicted  on  the  broad,  un- 
warranted assumption  that  the  probable  life  of  locomo- 
tives as  a  class  may  be  made  the  basis  of  the  calcula- 
tion. 

Stated  generally  the  following  is  true : 

Let  rm,  rn,  etc.,  represent  the  replacement  requirement 
computed  by  Sinking  Fund  methods  for  an  actual  service  of 
n,  m,  etc.,  years  as  the  case  may  be. 

Let  n  represent  the  probable  life  in  years. 

Let  m  represent  any  number  of  years  less  than  n. 

Then 

r         T*    "^  j*    _-  -  «• 

From  which,  rn  _  m  +  rn  +  m  >  2  ra 
Similarly  it  can  be  shown  that: 

rn  .  m  +  2  (rn  +— )  >  3  rn 

2 

and        rD  _  m  +  3  (n,  +— )  >  4  rn 

3 

This  means  that  the  amortization  or  replacement 
allowance  for  two  or  more  articles  having  different 
terms  of  usefulness  should  always  be  larger  than  the 
allowances  for  the  same  articles  if  they  be  assumed  to 
fail  altogether  at  the  average  of  the  individual  terms. 
The  amortization  or  replacement  if  estimated  from 
the  probable  life  new  of  any  article  will  be  too  small. 

In  the  practical  application  of  this  fact  the  valua- 
tion engineer  when  called  upon  to  determine  how 
much  should  be  in  a  replacement  fund  or  how 
much  capital  should  have  been  amortized  out  of  the 
ascertained  earnings,  will  always  find  himself  in  trou- 
ble. How  he  will  get  out  of  it  depends  upon  the  cir- 
cumstances in  each  case. 

There  is  some  satisfaction  in  knowing  that  these 
and  other  like  difficulties  can  be  avoided  in  the  regu- 
lation of  rates,  if  the  valuation  authorities  will  have 
the  courage,  as  they  have  the  right,  to  adopt  some 
method  of  procedure  under  which  accrued  depreciation 


GENERAL     COMMENTS  33 

need  not  be  estimated.  The  writer  has  intimated  what 
this  procedure  should  be  and  he  has  fully  described  it 
in  the  various  publications  already  referred  to.  It 
need  only  be  stated  here  that  he  has  named  it,  the  Un- 
limited Life  method,  that  its  correctness  is  unques- 
tioned, that  it  does  not  involve  any  estimate  of  accrued 
depreciation  and  that  the  current  replacement  require- 
ment does  not  have  to  be  ascertained  with  more  than 
a  fair  degree  of  approximation. 


34  PUBLIC     UTILITY    RATE     FIXING 


CHAPTER  II 

ELEMENTS  DESERVING  SPECIAL  CONSIDERA- 
TION WHEN  RATES  ARE  TO 
BE  FIXED 

A— OBSOLESCENCE 

Obsolescence  Cannot  be  Predicted 

An  appliance,  machinery  or  a  process  of  manufac- 
ture in  use  by  a  public  utility  may  under  efficient  manage- 
ment at  any  time  be  superseded  by  a  better  device  or 
process.  When  this  is  the  case  more  or  less  property  is 
usually  discarded,  which,  under  the  conditions  as  they 
prevailed  when  this  property  first  came  into  use,  should 
have  served  for  many  years  longer.  Obsolescence  has 
forced  its  abandonment. 

The  knowledge  that  obsolescence  may  shorten  the 
term  of  usefulness  of  a  machine  or  of  portions  of  any 
plant  used  in  the  public  service  has  prompted  valuation 
experts  and  the  rate  regulating  authorities  to  attempt 
estimates  of  the  allowances  which  should  be  made  in  the 
earnings  to  cover  the  prospective  abandonment  of  prop- 
erty due  to  this  cause. 

The  last  word  has  not  been  said  in  the  discovery  of 
new  forces  in  nature  and  their  adaptation  to  human 
requirements.  It  is  the  belief  of  many  engineers,  for 
example,  that  the  internal  combustion  engine  will  put  the 
old  types  of  marine  engines  of  ocean  freighters  on  the 
scrap  heap,  and  yet  the  older  type  under  gradual  develop- 
ment to  its  present  high  state  of  efficiency  has  main- 
tained itself  for  more  than  a  hundred  years. 

The  use  of  oil  in  place  of  coal,  not  alone  as  a  pro- 
ducer of  gas  but  also  as  fuel  in  the  production  of  steam, 
has  caused  appliances  and  machinery  to  be  abandoned 
which  would  otherwise  have  continued  in  service.  No 
one  today  can  be  sure  which  of  two  extremes  is  most 
likely  to  prove  true,  whether,  for  example,  the  last  word 
has  been  said  in  the  manufacture  of  gas  and  there  will 


ELEMENTS     DESERVING     CONSIDERATION       35 

be  no  further  abandonment  of  standard  gas  making  ap- 
pliances and  processes,  or  whether,  due  to  exhaustion  of 
sources  of  oil,  or  due  to  other  causes,  there  may  not  be 
some  new  substitute  for  oil  or  for  the  gas  itself  found 
which  will  render  some  of  the  most  modern  appliances 
of  the  day  obsolete  in  the  near  future. 

Past  experiences  in  the  matter  of  abandonment  of 
property,  due  to  obsolescence,  is  not  a  dependable  guide 
to  what  may  happen  in  the  future.  In  this  respect  there 
is  a  difference  between  the  failures  from  this  cause  and 
those  which  result  from  the  wear  and  tear  of  use  and 
from  the  somewhat  less  regular  failures  through  acci- 
dents incident  to  human  frailty,  fire  and  similar  causes. 
In  the  one  case  the  basis  for  a  satisfactory  prediction  is 
lacking.  In  the  other  the  probability  of  events  occurring 
in  the  future  can  be  predicated  with  some  confidence 
upon  what  has  occurred  in  the  past.  There  is  a  differ- 
ence, too,  between  replacements  made  as  the  result  of 
obsolescence  and  replacements  due  to  failure  from  other 
causes.  In  the  case  of  obsolescence  the  replacement  is 
made  with  some  device  which  betters  the  service — the 
output  costs  less,  or  the  service  is  made  more  reliable  or 
,he  quality  of  the  output  is  improved,  while  in  the  case 
of  ordinary  replacements  or  renewals  the  betterment  of 
service  is  not  a  necessary  incident. 

Treatment  of  Obsolescence  and  Replacement 
Compared 

It  is  proper  to  charge  the  rate-payer  with  the  cost 
of  replacement  when  property  fails  from  ordinary  cause? 
and  to  let  the  earnings,  therefore,  cover  a  replacement 
increment  during  the  useful  life  of  any  item  of  property 
and  to  base  the  charge  on  the  ordinary  replacement  re- 
quirement as  determined  for  such  property.  Not  so, 
however,  in  the  case  of  obsolescence.  This  will  be  made 
plain  by  the  following  considerations. 

There  would  be  no  obsolescence  if  the  improved 
machinery  or  the  new  process  which  takes  the  place  of 
that  which  is  being  replaced  did  not  result  in  some  advan- 
tage to  some  one.  If  the  obsolete  property  were  treated 
a?  though  its  failure  had  been  correctly  foreseen  and  as 


36  PUBLIC     UTILITY     RATE     FIXING 

though  funds  for  its  replacement  had  already  been  col- 
lected from  the  rate-payers  and  if  the  owner  had  not  in 
fact  collected  sufficient  funds,  and  if  thereupon  the  re- 
maining value  of  the  obsolete  property  or  the  capital 
investment  at  which  it  was  carried  in  the  rate-base  were 
immediately  ignored,  and  rates  were  established  as  though 
the  abandoned  proper  had  never  been  in  use,  the  rate- 
payer would  at  once  get  the  full  benefit  of  the  innovation 
and  the  owner  would  have  made  a  sacrifice  of  capital 
which  he  could  perhaps  have  avoided  by  being  a  less 
efficient  manager  and  holding  to  the  older,  less  efficient 
plan  of  operation.  Let  it  be  known  that  the  usual  pro- 
cedure will  be  to  forecast  failures  by  obsolescence  and 
to  amortize  the  capital  in  such  properties  on  the  basis 
of  assumed  average  conditions  which  means  inadequate 
amortization  in  many  cases,  and  there  will  no  longer  be 
any  inducement  to  the  owner  to  improve  the  efficiency 
of  his  plant.  He  will  conclude  that  it  will  be  safest  not 
to  use  new  inventions  or  to  introduce  new  processes  so 
long  as  a  sacrifice  of  capital  is  thereby  involved.  He 
might,  in  making  an  innovation,  find  that  he  had  on  his 
hands  abandoned  property,  the  cost  of  which  has  not  only 
not  been  fully  returned  to  him  but  concerning  the  further 
amortization  of  which  the  established  rules  of  rate  regu- 
lating bodies  may  give  no  adequate  assurance. 

Obsolescence  Should  Affect  Rates  After,  Not  Before, 
the  Event 

It  seems  self-evident  that  when  the  introduction  of 
a  new  invention,  whether  the  same  applies  to  a  machine 
or  to  a  process,  reduces  the  cost  of  operation,  the  result- 
ing advantage  should  go  to  both  the  owner  of  the  utility 
and  the  rate-payer.  But  it  is  also  true  that  in  such  event 
there  will  be  no  hardship  imposed  on  the  rate-payer  if 
the  benefit  of  reduced  cost  of  producing  the  output,  does 
not  come  to  him  immediately.  A  reasonable  procedure 
would  therefore  be,  in  all  such  cases,  to  allow  the  rates 
to  remain  as  they  would  have  been  without  the  new 
process,  unless  a  reduction  would  result  in  increased  de- 
mand and  greater  net  profit  to  the  owner,  at  least  long 
enough  to  amortize  so  much  of  the  original  plant  as  is 


ELEMENTS     DESERVING    CONSIDERATION       37 

thereby  rendered  useless  and,  thereafter,  to  so  adjust 
rates  that,  for  a  suitable  period  of  time,  the  benefit  of 
the  reduced  cost  will  be  shared  on  a  fair  basis  by  the 
owner  and  the  rate-payer.  Any  treatment  less  favorable 
to  the  owner  of  a  public  utility  would  discourage  the 
introduction  of  innovations  if  they  involve  further  invest- 
ment of  capital  and  would  make  for  inefficient  rather 
than  for  efficient  management.  The  owner  must  not  be 
expected  to  consent  to  an  increase  of  hazard  without  an 
increase  of  profit. 

The  practice  of  attempting  to  foresee  obsolescence 
and  of  burdening  the  rate-payer  before  the  failure  by 
obsolescence  with  the  charge  that  is  necessary  to  amortize 
the  capital  which  obsolescence  renders  useless,  is  not 
alone  unwise  but  unjust.  It  is  not  fair  to  the  rate-payer 
because  those  who  pay  rates  before  the  betterment  is 
made  should  not  be  made  to  pay  for  the  advantage  which 
will  come  to  those  who  pay  rates  after  the  betterment 
has  been  made ;  it  is  not  fair  to  the  owner  because  while 
apparently  increasing  his  earnings  it  will  act,  as  do  all 
high  charges  for  service,  as  a  deterrent  upon  the  exten- 
sion of  business  and  because  there  will  be  cases  where 
by  error  in  the  estimate  of  time  allowance  for  obsoles- 
cence the  owner  will  be  called  upon  to  make  a  sacrifice 
when  due  to  obsolescence  property  is  abandoned,  which 
can  not  be  offset  against  the  advantage  that  may  come 
to  the  owners  of  other  utilities  who  benefit  by  an  allow- 
ance for  something  which,  in  their  case,  never  happens. 
The  obsolescence  will,  in  many  cases,  occur  before  any 
adequate  provision  has,  in  fact,  been  made. 

Illustration 

To  illustrate  the  problem  which  is  presented  when 
one  type  of  machinery  is  replaced  by  a  better  type,  let  it 
be  assumed  that  the  machinery  of  an  old  style  generating 
station  has  been  replaced  by  steam  turbo  generators,  that 
the  old  machinery  had  been  in  use  for  some  years,  that 
it  was  still  in  first  class  condition  but  that  its  abandon- 
ment was  advisable  because,  all  factors  being  taken  into 
account,  the  generation  of  electric  energy  will  be  cheaper 
with  the  new  installation. 


38  PUBLIC     UTILITY     RATE     FIXING 

Suppose  that  the  remaining  or  present  value  of  the 
abandoned  machinery,  as  a  part  of  the  utility,  was  $200,- 
000  (original  cost  $250,000  less  $50,000  earned  replace- 
ment), and  that  $75,000  was  realized  from  its  sale  after 
abandonment.  Suppose  further  that  an  appraisal  of  the 
new  machinery  after  its  installation  shows  that  it  should 
be  introduced  into  the  rate-base  at  $150,000. 

Two  cases  are  possible,  either  the  $50,000  of  earned 
replacement  increments  have  actually  been  returned  to 
the  owner  and  have  reduced  the  remaining  investment 
from  the  original  $250,000  to  $200,000,  or  the  $50,000 
are  carried  in  a  replacement  fund.  In  the  first  case  on 
the  assumption  that  only  property  in  use  is  carried  in 
the  rate-base,  there  would  be,  after  the  new  machinery 
is  installed,  a  value  to  be  taken  into  account  reduced  by 
the  $200,000  and  increased  by  the  cost  of  the  new  ma- 
chinery, that  is,  $150,000  less  the  sale  value  of  the  old, 
or  $150,000  — $75,000  =  $75,000.  The  result  would  be 
a  net  reduction  of  present  value,  as  appearing  in  the 
rate-base,  of  $125,000.  This  amount,  on  some  theory 
other  than  "present  value,"  could  be  retained  in  the  rate- 
base  subject  to  amortization,  or  it  could  be  transferred 
to  profit  and  loss  or  some  other  account  where  it  would 
be  carried  until  together  with  interest  thereon  it  is  com- 
pletely wiped  out.  In  the  seconl  case  the  old  machinery 
would  have  been  carried  in  the  rate-base,  at  the  time  of 
its  obsolescence,  at  $250,000,  the  original  cost,  undimin- 
ished  by  accrued  depreciation,  but  this  amount  would 
have  been  offset  in  part  by  the  $50,000  in  the  replace- 
ment fund.  By  the  transfer  of  this  sum  the  $250,000 
would  be  reduced  to  $200,000  and  there  would  then  be 
an  addition  of  the  net  cost  of  the  new  machinery,  or 
$75,000.  The  rate-base  would  include  on  account  of  both 
old  and  new  machinery  an  amount  of  $275,000,  which  is 
$125,000  in  excess  of  what  should  be  in  it  if  original 
investment  in  property  in  use  is  the  determining  factor. 
In  either  event  there  will  be  $125,000  to  be  either  carried 
indefinitely  in  the  rate-base  or  to  be  amortized  within  a 
reasonable  time. 

Unless  the  owner  felt  reasonably  certain  that  the 
$125,000  would  be  returned  to  him  in  some  way,  he 


ELEMENTS     DESERVING     CONSIDERATION        39 

would  not  prematurely  discard  the  old  machinery.  If  as 
a  result  of  the  change  rates  are  reduced  to  a  point  ex- 
cluding interest  on  and  amortization  of  the  $125,000  the 
owner  will  have  made  a  sacrifice  for  the  benefit  of  the 
rate-payer  out  of  all  reason.  If,  however,  the  rates  re- 
main undisturbed  for  a  time,  then,  during  this  time  the 
excess  of  earnings,  over  operating  expenses,  will  be 
larger  than  it  had  been  under  the  original  plan  of  opera- 
tion by  the  amount  that  the  cost  of  operation  has  been 
cut  down.  This  increase  of  net  earnings,  perhaps  cut 
down  somewhat  by  voluntary  action  of  the  owner,  should 
be  used  to  amortize  the  $125,000  and  interest  thereon, 
and  when  this  is  accomplished  a  reduction  in  rates  would 
naturally  ensue,  and  the  rate-payer  would  share  in  the 
benefit  resulting  from  the  reduced  cost  of  operation. 

B— LOSSES  FROM  FORTUITOUS  EVENTS 

Amortization  of  Losses  from  Fortuitous  Events 

Losses  of  magnitude  which  result  from  floods, 
earthquakes,  volcanic  eruptions  and  the  like  and  in 
general,  losses  against  which  the  owner  can  not  in- 
sure, belong  to  a  class  of  sacrifices,  which  like  those 
due  to  obsolescence  should  be  made  good  to  the  own- 
er of  the  utility  after  the  event,  by  the  public,  that 
is  to  say,  by  the  rate-payers.  Such  losses  can  not 
be  forecast.  They  should  not  fall  entirely  on  the 
owner  of  the  utility.  In  some  fashion  and  to  a  fair 
extent,  they  should,  in  the  course  of  time,  be  amor- 
tized out  of  earnings.  As  a  rule  no  provision  for 
other  than  ordinary  risks  is  made  in  the  allowed  rate 
of  return.  Consequently,  after  a  catastrophe,  for 
which  the  owner  is  not  responsible,  but  which  entails 
a  large  investment  of  new  capital  to  rehabilitate  a 
public  utility  plant,  there  should  be  some  provisions 
for  amortizing  the  loss.  It  will,  in  such  event,  be  bet- 
ter to  let  the  amortization  take  place  within  a  reason- 
able time  rather  than  to  carry  an  equivalent  sum  in 
the  rate-base  as  though  it  were  a  permanent  though 
unproductive,  interest-bearing  investment. 


40  PUBLIC     UTILITY     RATE     FIXING 

It  will  perhaps  be  claimed,  by  some,  that  such 
losses  should  not  be  differentiated  from  the  ordinary 
losses  due  to  unforeseen  causes,  and  that  whatever 
hazard  is  involved  in  any  enterprise  has  unqualifiedly 
been  assumed  by  the  owner  of  the  utility.  Under  such 
a  theory  the  allowance  for  hazard  should  at  all  times 
be  liberal  enough  to  compensate  the  owner  for  the 
chance  which  he  takes  of  at  some  time  suffering  ma- 
terial loss.  He  would  be  compelled  to  take  the 
gambler's  chance  and  the  rate-payer  should  stand  the 
higher  rate.  Under  such  a  practice  there  would  be  an 
owner  here  and  there  who  would  suffer  large  loss, 
while  the  great  majority  of  owners,  escaping  the 
great  catastrophes,  would  get  what  really  should  be 
paid,  in  the  exceptional  case,  to  the  unfortunate  owner. 
Under  such  a  treatment  of  this  matter,  the  tax  for  the 
risk  would  fall  upon  those  who  are  paying  rates  be- 
fore a  catastrophe  occurs,  as  well  as  upon  those  who 
receive  service  from  the  rehabilitated  works.  The 
more  logical  procedure  would  be  to  relieve  the  rate- 
payers from  the  burden  of  making  the  inadequate 
provision  for  catastrophes  which  may  never  occur  and 
letting  the  loss  that  actually  results  from  a  catastro- 
phe be  met  out  of  future  earnings.  The  usual  provi- 
sion for  meeting  losses  which  result  from  such  fortu- 
itous events  as  are  here  under  discussion,  is  inade- 
quate. The  owner  does  not,  as  in  the  case  of  losses 
which  must  be  made  good  by  assurance  companies, 
get  the  full  benefit  of  the  allowance  for  risk  which  is 
distributed  in  small  measure  or  is  at  least  supposed 
to  be  distributed  among  all  public  utility  owners  and 
is  supposed  to  be  collected  in  the  earnings.  The  own- 
er's share  in  this  risk  allowance  is  only  a  proportionate 
one  while  the  loss,  when  it  occurs,  can  not  be  distrib- 
uted to  the  other  utilities  of  the  country  which  escape 
such  loss,  but  falls  in  its  entirety  upon  the  one  utility 
that  may  be  affected  thereby. 

In  recognition  of  the  fact  that  most  utilities 
escape  such  losses,  the  usual  allowance  in  the  public 
utility  rates  for  the  element  of  risk  is  small  and  prob- 


ELEMENTS     DESERVING     CONSIDERATION        41 

ably  in  most  cases  negligible.  The  allowance  for  man- 
agement, for  business  hazards,  together  with  the  al- 
lowance for  participation  in  the  general  prosperity  of 
the  country,  in  short  the  profit  allowance,  would  prob- 
ably in  few,  if  any  cases,  be  materially  reduced,  if  this 
element  of  risk  were  entirely  eliminated. 

In  all  cases  in  which  this  interpretation  of  the 
present  day  procedure  is  substantially  true,  it  would 
be  unfair  to  an  owner  whose  public  utility  plant  sus- 
tains material  damage  by  flood,  by  earthquake  or  by 
other  fortuitous  event,  against  which  insurance  is  im- 
possible, to  let  the  entire  loss  fall  upon  him  without 
recourse.  That  such  losses  should  in  some  way  ulti- 
mately fall  upon  those  who  are  served  by  the  utility 
seems  self-evident.  The  most  equitable  procedure 
would  be  to  let  them  be  borne  by  the  rate-payers 
future.  But  as  they  can  not  be  foreseen  the  practical 
alternative  would  seem  to  be  to  let  them  fall  in  the 
before  the  event  as  well  as  by  the  rate-payers  of  the 
future  as  would  be  the  case  if  the  utility  were  publicly 
and  not  privately  owned. 

In  the  case  of  a  business  not  subject  to  regulation 
the  opportunity  to  make  up  for  past  losses  exists  if 
larger  profits  can  be  made  by  charging  what  the  traf- 
fic will  bear.  Owners  of  public  utilities  should  be  al- 
lowed to  recoup  their  losses,  if  they  can  do  so  without 
charging  rates  unreasonably  high. 

C— HAZARD,    MANAGEMENT   AND   THE 
UNEARNED  INCREMENT 

The  Allowance  for  Hazard,  for  the  Unearned  Incre- 
ment and  for  Management  Should  Not  be 
Based  on  Value 

All  rate  regulating  authorities  are  devoting  much 
thought  and  study  to  the  establishment  of  a  proper 
basis  of  calculation  when  the  rates  to  be  charged  by 
public  utilities  are  to  be  fixed. 

The  highest  court  has  said  that  value  must  be  the 
starting  point  and  the  attempt  is  therefore  generally 


42  PUBLIC     UTILITY     RATE     FIXING 

made  to  comply  with  this  apparent  requirement  of  the 
court.  The  result  is  the  use  of  a  rate-base  conforming 
to  "present  value"  or  to  something  that  may  be  called 
present  value,  even  though  in  making  value  the  rate- 
base  it  is  occasionally  found  necessary  to  read  new 
meanings  into  the  word  value.  After  this  value  has 
been  ascertained  in  some  fashion  the  owner  of  the 
utility  is  allowed  to  earn  a  return  thereon,  usually 
somewhat  in  excess  of  what  would  be  a  fair  interest 
return  on  money  for  investment  in  enterprises  of  like 
character. 

When  there  is  included  in  the  rate-base  thus  es- 
tablished an  allowance  for  "going  value,"  the  interest 
return  allowed  and  earned  on  this  "going  value,"  to- 
gether with  earnings  to  cover  the  excess  of  the  return 
rate  over  the  ordinary  interest  rate,  is  the  owner's 
compensation  for  hazards  and  for  management  and 
may  also  cover  some  participation  in  the  prosperity 
and  increasing  values  of  the  property  in  the  com- 
munity which  is  served  by  the  utility.  If  the  allow- 
ance for  hazards  has  been  correctly  estimated,  the 
owner  will  in  the  long  run  get  little  or  no  advantage 
therefrom,  because  this  allowance  will  be  offset 
from  time  to  time  by  losses  or  sacrifices  of  various 
kinds.  The  allowance  for  participation  in  the  general 
prosperity  is  not  always  recognized  as  being  due  to 
the  owner  for  the  reason  that  a  part  thereof,  under 
the  prevailing  system  of  using  value  as  the  basis  of 
the  calculation,  makes  its  appearance  in  the  increase 
of  real  estate  values  and  in  the  increasing  values  re- 
sulting from  the  gradual  but  recognized  rise  in  the 
price  of  materials  and  the  rise  in  the  wage  scale.  And 
yet  every  utility  helps  to  create  the  general  prosperity. 
It  adds  to  the  unearned  increment  of  the  vacant  lot 
and  unused  field  as  well  as  to  that  of  the  lot  or  field 
whose  owner  is  a  rate-payer.  Some  share  of  this 
prosperity  should  go  to  the  utility,  even  when  its 
property  items  do  not  include  appreciating  real  estate. 
But,  even  when  the  earnings  cover  fair  allowances 
for  hazard  and  for  the  unearned  increment,  the  obliga- 
tion of  the  public  to  the  owner  of  the  utility  is  not  yet 


ELEMENTS     DESERVING     CONSIDERATION        43 

fully  discharged.  There  should  be  proper  compen- 
sation for  management.  It  is  not  enough  to  allow  the 
bare  salaries  of  those  who  are  entrusted  with  the 
management  and  operation.  The  owner  is  entitled  to 
something  more.  He  has  brought  into  being  and  has 
placed  at  the  service  of  the  community,  an  effective 
organization  the  stability  and  efficiency  of  which  is 
guaranteed,  as  in  the  case  of  a  corporation-owner,  by 
the  character,  judgment  and  business  experience  of  a 
board  of  directors  selected  by  the  stock  holders.  The 
existence  of  the  corporation,  the  business  ability  of  its 
directors  resulting  in  the  energetic  control  of  its 
affairs,  the  cash  contribution  by  stock  holders,  the  suc- 
cessful operation  of  the  enterprise,  or,  in  the  case  of  the 
new  venture,  the  implied  guarantee  of  success,  affords 
the  basis  for  making  loans  and  extends  the  ability  cf 
the  public  to  enjoy  transportation  facilities  or  electric 
service,  or  gas  and  water  supplies  that  might  other- 
wise long  be  out  of  reach  by  reason  of  the  limited 
borrowing  capacity  and  lack  of  business  ability  of 
municipal  organizations.  The  owner  should  be  fully 
compensated  for  the  service  rendered.  The  mere  pay- 
ment of  salaries  to  those  who  are  actively  engaged  in 
the  management  is  not  full  compensation  for  this 
service.  The  compensation  for  management  even 
though  not  usually  specifically  referred  to  or  separated 
from  what  might  be  called  broadly  the  profit  allow- 
ance, makes  its  appearance  as  a  part  of  the  excess  of 
earnings  above  the  actual  cost  of  money  (interest  with 
due  regard  to  discounts  and  commissions)  after  allow- 
ing for  operating  expenses  and  replacement  require- 
ments. 

Volume  of  Business  to  be  Considered 

That  there  should  be  something  in  the  earnings 
as  compensation  for  management  can  hardly  be  ques- 
tioned. There  will,  however,  be  difficulty  in  bringing 
the  same  into  a  satisfactory  relation  to  the  rate-base. 
This  is  equally  true  of  the  allowance  which  should  be 
made  for  the  participation  in  the  general  prosperity 
and  is  true  to  a  less  extent  of  the  hazard  allowance. 
All  of  these  elements  which  should  be  covered  in  the 


44  PUBLIC     UTILITY    RATE     FIXING 

earnings  are  more  closely  related  to  the  volume  of 
business  than  to  the  capital  invested  in  the  enterprise 
or  to  any  rate-base  built  up  from  "value." 

It  happens  occasionally  that  a  public  utility  con- 
cern does  a  large  volume  of  business  on  a  small  invest- 
ment. Some  of  the  express  companies  belong  in  this 
class.  The  case  may  readily  be  conceived,  of  such  a 
concern  which  rents  its  office  facilities  and  operates 
under  contract  with  railroad  and  steamship  companies 
and  which  outside  of  its  trucks  and  other  vehicles  for 
local  delivery,  has  made  no  investment  of  any  moment. 
It  would  be  in  vain  in  such  a  case  to  attempt  a  regula- 
tion of  rates  based  solely  upon  a  fair  return  upon  the 
invested  capital.  The  whole  field  must  be  brought 
into  view.  The  volume  of  business  transacted  is,  in 
such  a  case,  equally  as  important  an  element  for  con- 
sideration as  is  a  rate-base  when  a  limit  is  to  be  set 
upon  the  earnings. 

An  express  company,  as  here  assumed,  has  no 
appreciating  property.  Its  share  in  the  unearned  incre- 
ment of  the  country  should  be  brought  into  some 
relation  to  the  amount  of  service  which  it  renders, 
that  is,  to  the  volume  of  its  business. 

The  compensation  for  management  likewise  is 
intimately  related  to  and  should  be  figured  with  the 
volume  of  business  as  the  starting  point. 

It  would,  of  course,  be  quite  as  feasible  to  start 
with  the  total  cost  of  operation  instead  of  with  the 
gross  annual  receipts  when  determining  what  should 
be  allowed  for  management  and  what  should  be  al- 
lowed to  cover  participation  in  general  prosperity,  but 
the  gross  income  as  a  basis  has  obvious  advantages. 
Bookkeeping  will  be  simplified  and  the  control  is  more 
readily  effected.  The  annual  cost  of  operation  will 
be  more  difficult  to  ascertain  and  will  show  greater 
relative  fluctuations  than  the  annual  gross  income,  and 
for  the  same  allowance  in  the  earnings,  the  per  cent  of 
the  annual  gross  income  will  be  less  than  the  per  cent 
of  the  operating  cost,  thus  resulting  in  greater  stabil- 
ity of  the  percentage  allowance  when  once  fixed. 


ELEMENTS     DESERVING    CONSIDERATION        45 

From  the  standpoint  of  the  public,  there  can  be 
but  little  question  that  the  compensation  for  manage- 
ment should,  as  here  suggested,  be  brought  into  fair 
relation  to  the  volume  of  business  instead  of  making 
its  appearance  in  the  interest  allowance  on  an  arbi- 
trarily established  or  assumed  "going  value."  No 
basis  has  yet  been  discovered  for  estimating  "going 
value"  except  capitalization  of  net  profits.  When, 
therefore,  "going  value"  deduced  from  the  opinion  of 
experts,  supported  chiefly  by  assumptions,  as  distin- 
guished from  cost  of  developing  business,  is  included 
in  a  rate-base,  the  procedure  must  appear  illogical 
to  the  rate-payer  and  will  always  remain  subject  to 
attack,  both  as  to  principle  and  amount.  The  alterna- 
tive procedure  which  is  now  suggested  but  which  is 
novel  and  is  here  perhaps  for  the  first  time  brought  to 
the  attention  of  a  court,  should  appeal  to  all  concerned 
as  logical  and  in  accord  with  the  common  practice  in 
ordinary  business  affairs  of  allowing  commissions 
based  on  the  magnitude  of  the  involved  transaction. 

To  summarize: — 

No  argument  seems  to  be  required  to  prove  the 
owner's  right  to  compensation  for  management. 

This  compensation  can  not  be  brought  into  any 
definite  or  satisfactory  relation  to  what  I  believe 
should  be  designated  as  the  natural  rate-base,  which 
is  the  legitimate  investment,  usually  determined  from 
cost  of  reproduction  including  an  allowance  for  cost 
of  developing  business  but  without  deduction  of 
depreciation,  because  the  amount  of  business  bears 
no  definite  relation  to  the  amount  of  capital  invested. 

If  this  compensation  is  brought  into  some  relation 
to  value  (including  in  value  the  going  value  of  the 
concern),  then  the  reasoning  will  be  in  a  circle  and 
the  proceeding  will  be  illogical  and  absurd. 

It  will  always  be  fair  to  both  the  owner  and  the 
rate-payer  to  let  this  compensation  be  brought  into  a 
proper  relation  to  the  gross  income. 

The  owner's  share  in  the  general  prosperity  of  the 
community,  under  the  customary  procedure  of  the 
rate  regulating  authorities,  is  recognized  in  those  cases 


46  PUBLIC     UTILITY    RATE     FIXING 

in  which  the  utility  plant  includes  property  which  is 
appreciating  in  value.  There  may  be  some  unearned 
increment,  in  addition  thereto,  concealed  in  the  allow- 
ance for  "going  value"  and  in  a  rate  of  return  in  excess 
of  the  cost  of  borrowed  money,  but  so  long  as  one 
concern  gets  the  unearned  increment  in  large  amount 
due  to  increasing  values  of  real  estate  and  other  con- 
cerns apparently  get  none,  the  system  will  be  at  fault. 
The  participation  in  general  prosperity  should,  there- 
fore, also  be  brought  into  relation  to  the  volume  of 
business  and  not  to  a  rate-base. 

The  business  hazard  is  contingent  in  part  on  the 
amount  of  capital  which  the  owner  has  invested  and 
in  part  on  the  cost  of  operation.  The  allowance  for 
hazard  if  considered  apart  from  obsolescence  and  from 
losses  due  to  fortuitous  events,  which  should  ulti- 
mately fall  on  the  public  and  not  on  the  owner,  will 
ordinarily  be  small  and,  if  expressed  in  figures  at  all, 
can  be  readily  brought  into  relation  to  the  volume  of 
business.  It  is  not  logical  to  bring  it  into  relation  to 
value  which  may  be  made  up  largely  of  intangibles. 
It  is  not  logical  either  to  bring  it  into  definite  relation 
to  the  natural  rate-base.  Hazard,  too,  therefore,  had 
best  be  brought  into  some  relation  to  the  volume  of 
business. 


D— VOLUME  OF  BUSINESS 

Public  Utility  Rates  and  the  Volume  of  Business 

In  presenting  the  following  ideas  relating  to  the 
profit  which  the  public  utility  should  earn,  the  writer 
disclaims  any  intent  to  appear  as  an  advocate  of  limit- 
ing the  profit  which  the  owner  of  the  public  utility  can 
make  at  reasonable  charges  for  the  service  rendered 
or  the  commodity  furnished.  When  the  owner  suc- 
ceeds by  efficient  management  in  keeping  operating 
expenses  low  he  is  entitled  to  a  suitable  reward.  His 
treatment  by  those  who  are  charged  with  regulating 
rates  should  be  such  that  efficient  management  will  be 
encouraged  and  not  discouraged.  The  suggestions 


ELEMENTS     DESERVING     CONSIDERATION        47 

which  follow  should  be  considered  in  the  light  of  these 
qualifying  statements. 

The  compensation  to  which  the  owners  of  public 
utilities  are  entitled  for  management  and  business 
hazards,  or,  speaking  broadly,  the  profit  to  which  they 
are  entitled,  can  not  be  brought  into  any  definite,  uni- 
versally applicable  relation  to  the  capital  invested  in 
such  enterprises.  Another  element,  the  volume  of 
business,  deserves  consideration  in  this  connection. 

That  there  should,  in  the  case  of  every  legitimate 
public  utility,  be  some  profit  will  be  admitted.  This 
profit  will  appear  as  an  excess  of  earnings,  present  and 
prospective,  over  a  fair  allowance  for  the  use  of  the 
money  invested  in  the  utility,  provision  having  first 
been  made  for  operating  expenses  and  replacement 
requirements.  It  has  been  customary  heretofore  to 
use  value  as  the  starting  point  when  rates  are  to  be 
fixed  with  inclusion  of  some  allowance  for  'going 
value.'  The  general  practice  also  prevails  of  introduc- 
ing into  the  calculation  a  rate  of  return  on  the  so- 
called  "fair  value"  of  the  property,  higher  than  ordin- 
ary interest  rates.  Without  giving  special  considera- 
tion to  the  question  of  compensating  the  owner  for 
management  and  of  allowing  him  to  share  in  the 
general  prosperity  of  the  community,  which  prosperity 
he  has  helped  to  create,  a  way  has  thus  been  found  to 
permit  the  utility  to  yield  some  profit.  Under  such 
procedure  there  will  be  cases,  however,  in  which  the 
profit  will  be  very  large  and  may  be  an  onerous  burden 
upon  the  rate-payer,  as  in  the  case  of  certain  utilities 
in  which  the  amount  of  invested  capital  is  large  when 
compared  with  their  annual  gross  income  and  particu- 
larly if  the  ultimate  profit  is  swelled  by  the  increasing 
value  of  large  holdings  of  real  estate.  And  there  will 
be  other  cases  in  which  the  profit  may  be  small  and 
inadequate  under  reverse  circumstances,  when  the 
volume  of  business  is  large  in  comparison  with  the 
invested  capital.  As  an  example  of  the  first  kind, 
certain  water  supply  enterprises  on  the  Pacific  Coast 
might  be  cited.  These  not  only  require  the  investment 
of  relatively  large  amounts  of  capital  but  in  connection 


48  PUBLIC    UTILITY    RATE     FIXING 

with  some  of  them  large  areas  of  land  are  held  for 
reservoir  and  related  purposes.  As  an  example  of  the 
second  kind,  certain  express  companies  may  be  noted 
which  operate  under  contract  with  other  transporta- 
tion companies  and  which  do  a  large  business  on  a 
small  investment  of  capital. 

Profit  in  Relation  to  Volume  of  Business 

The  proposition  has,  therefore,  been  submitted  as 
noted  in  a  preceding  article  of  this  series,  that  the 
equitable  arrangement  would  be  to  bring  the  profit, 
covering  compensation  for  management,  for  hazard, 
and  for  participation  in  general  prosperity,  into  some 
definite  relation  to  the  volume  of  business,  that  is,  into 
some  fixed  relation  to  the  amount  of  annual  gross 
income. 

When  the  procedure  is  followed  of  applying  the 
interest  return  to  a  rate-base  determined  from  the 
amount  of  capital  legitimately  invested,  including  cost 
of  developing  the  business,  cost  of  franchises,  water- 
rights  and  the  like,  but  without  deduction  of  accrued 
depreciation,  a  reasonable  profit  allowance  should  not 
be  difficult  to  determine.  If  the  interest  allowance  on 
the  rate-base  be  supposed  to  cover  the  full  cost  of 
borrowed  money,  due  regard  being  had  to  the  effect 
of  legitimate  discounts  and  commissions,  then  certain 
additions  to  earnings,  perhaps  about  as  below  set 
forth,  would  be  fair  and  proper,  this  being  in  lieu  of 
interest  on  the  additions  to  capital,  which  is  has  been 
customary  to  make  for  going  value,  or  other  intangible 
elements.  In  the  last  analysis  the  intangible  values 
result  from  the  capitalization  of  profit.  It  will,  there- 
fore, be  found  simpler  and  more  satisfactory  to  reverse 
the  usual  procedure  by  determining  what  the  profit 
should  be,  instead  of  starting  with  a  set  of  intangible 
values  which  after  all  result  from  the  capitalization  of 
an  ill-defined  arbitrary  subdivision  of  this  profit.  The 
following  profit  allowances  are  tentatively  suggested 
and  remain  subject  to  modification  upon  further 
study : — 


ELEMENTS     DESERVING     CONSIDERATION        49 


When   gross   income   is 


s    $          10,000    about     15% 

I       1,500   per  yi 

100,000 

14.5% 

14,500 

500,000 

13.5% 

67,500 

1,000,000 

12.5% 

125,000 

3,000,000 

10% 

300,000 

5,000,000 

9% 

450,000 

10,000,000 

8% 

800,000 

20,000,000 

7% 

1,400,000 

40,000,000 

6% 

2,400,000 

100,000,000 

5% 

5,000,000 

The  allowances,  here  suggested  as  additions  to  the 
interest  return  on  the  rate-base,  are  those  which  appear 
reasonable  under  ordinary  conditions.  They  should  be 
considered  subject  to  modification  to  fit  any  particular 
case  and  they  will  not  be  adequate  when  it  happens 
that  the  cost  of  the  output  has  been  materially  reduced 
by  the  introduction  of  a  new  invention  which  may  be 
the  result  of  efficient  management  and  skillful  opera- 
tion, and  the  use  of  which  may  entitle  the  owner  of 
the  utility  to  larger  profit  for  a  time  at  least  than  he 
would  expect  under  ordinary  circumstances. 

E— GOING  VALUE 

Going  Value  in  the  San  Francisco  Water  Rate 
Case 

Referring  to  going  value  as  an  element  deserving 
consideration  when  "value"  and  rate-base  are  treated 
as  synonymous  the  standing  Master  in  Chancery,  Mr. 
H.  M.  Wright,  in  his  recent  report  (August,  1917)  on 
the  value  of  the  properties  of  the  Spring  Valley  Water 
Company*,  says: 

"Such  additional  value,  if  it  is  to  be  recognized  here, 
is  obviously  not  of  a  separate  element  in  the  plant,  as  is  a 
conduit  or  a  reservoir,  but  of  the  plant  as  a  whole;  an  intan- 
gible value,  a  characteristic  of  the  unified  business  structure, 
inhering  in  every  part.  We  are  here  concerned,  however,  to 
estimate  this  value,  if  possible,  as  if  it  were  a  separate  thing." 

"Going  value  and  development  expense  are  not  synonym- 
ous. One  is  value;  the  other  is  cost,  either  actual,  where  the 
form  of  value  is  actual  investment  in  plant,  or  hypothetical, 
or  reproduced,  where  the  present  valuation  is  by  present  mar- 
ket value,  or  reproduction  cost." 


*Spring  Valley  Water  Co.   vs.   City  and  County  of  San 
Francisco  (rate  case). 


50  PUBLIC     UTILITY    RATE     FIXING 

That  there  is  always  difficulty  in  estimating  "go- 
ing value"  for  inclusion  in  the  rate-base  is  clear  from 
this  general  statement  and  has  been  universally  recog- 
nized. The  Master  quotes  Judge  W.  W.  Morrow, 
who  in  Bonbright  vs.  Geary  (D.  C.  Ariz.  1903)  210 
Fed.  44,  54,  56,  in  an  opinion  awarding  a  preliminary 
injunction,  said  that  a  going  value  should  be  allowed 
but  that,  though  often  presented  to  him,  he  had  never 
been  able  to  determine  a  proper  amount  upon  the  evi- 
dence submitted.  He  quotes  Judge  W.  C.  Van  Fleet, 
of  the  District  Court  of  Appeals,  San  Francisco  as  say- 
ing: 

"All  that  we  are  agreed  upon  is  that  upon  principle  there 
should  be  a  greater  value  attachable  to  a  going  concern  than 
one  which  is  merely  in  its  initiative  and  not  enjoying  the  ben- 
efit of  patronage." 

The  law  as  interpreted  by  the  courts  requires  that 
value  be  made  the  basis  of  the  calculation  when  the 
sufficiency  of  the  charges  for  service  or  for  the  output 
of  a  public  utility  is  in  question,  and  it  is  for  this  rea- 
son that  the  embarrassment  plainly  evidenced  by  these 
quotations  has  resulted. 

In  the  Spring  Valley  rate  case  already  referred 
to  the  Master  refers  to  the  difficulty  of  determining 
going  value  when  he  says : 

"It  is  the  intangible  nature  of  the  going  value  which 
makes  it  difficult  to  prove.  *  *  *  A  large  part  of  the  ag- 
gregate wealth  of  the  world  is  intangible,  without  separate 
market  value  or  ascertainable  reproduction  cost.  In  Adams 
Express  Company  vs.  Ohio,  166  U.  S.  185,  the  Supreme  Court 
sustained  the  taxation  of  an  express  company  upon  an  assess- 
ment of  property  largely  in  excess  of  the  value  of  tangible 
property.  The  intangible  property  is  at  one  place  ascribed 
to  franchises,  and  in  another  to  good  will;  the  name  is  not 
important." 

Justice  Brewer,  in  delivering  the  opinion  of  the 
Supreme  Court  in  this  case,  uses  the  following  lan- 
guage in  discussing  intangible  property: 

"To  say  that  there  can  be  no  such  intangible  property, 
that  it  is  something  of  no  value,  is  to  insult  the  common  in- 
telligence of  every  man.  *  *  This  is  eminently  a  practical 
age;  courts  must  recognize  things  as  they  are  and  as  possess- 


ELEMENTS     DESERVING     CONSIDERATION        51 

ing  a  value  which  is  accorded  to  them  in  the  market  of  the 
world." 

In  the  light  of  such  opinions  by  our  highest  tribu- 
nals, universal  recognition  of  the  fact  that  a  business 
may  have  going  value  is  to  be  expected.  Whether  or 
not  it  is  logical  or  wise  to  include  such  value  in  the 
rate-base  of  a  public  utility  is  another  question  else- 
where considered. 

Determination  of  Going  Value 

How  can  this  value  be  measured?  This  is  the 
problem  for  immediate  consideration  and  it  may  as 
well  be  stated  at  the  outset  that  no  acceptable  solution 
thereof  has  yet  been  offered. 

In  comparing  two  business  enterprises  alike  in 
all  respects  except  that  the  one  already  enjoys  a  fully 
developed  business  while  the  other  has  just  emerged 
from  the  construction  stage  and  is  about  to  begin  oper- 
ation, a  difference  in  value  is  readily  recognized,  and 
the  appraiser  of  the  first,  which  is  already  a  going 
concern,  would  naturally  be  inclined  to  take  the  view 
that  the  advantage  which  it  has  over  the  second  can 
be  measured  by  the  cost  of  developing  the  business 
and  that  this  cost  in  the  absence  of  other  satisfactory 
standards  may  be  accepted  as  an  index  of  the  "going 
value." 

This  appears  so  plausible  that  many  economists 
and  engineers  have  adopted  a  procedure  based  on  this 
reasoning  for  estimating  going  value.  They  have  rec- 
ognized, however,  that  while  cost  of  developing  busi- 
ness can  be  treated  as  an  investment  of  capital,  that 
it  would  not  always  be  fair  to  accept  the  actual  cost 
in  each  individual  case  as  representing  a  proper  allow- 
ance in  the.  rate-base  for  cost  of  development.  If  this 
were  done  it  would  be  equivalent  to  placing  a  premium 
upon  inefficiency  because  the  actual  cost  of  develop- 
ment would  naturally  be  greatest  in  the  case  of  the 
property  which  has  been  least  efficiently  managed.  To 
obviate  this  difficulty  recourse  has  been  had  to  the  re- 
production method  with  an  attempt  to  visualize  and 
estimate  the  cost  of  development  which  would  be  in- 
curred if  under  present  day  conditions  a  plant  had 


52  PUBLIC     UTILITY     RATE     FIXING 

to  be  reproduced.  In  the  application  of  this  method  of 
determining  the  advantage  expressed  in  terms  of 
money  which  the  going  concern  has  over  another  ex- 
actly the  same,  and  in  the  same  market,  but  with  busi- 
ness not  yet  established,  it  is  necessary  to  assume  that 
some  definite  time  will  elapse  between  the  completion 
of  the  system  and  the  full  development  of  the  business 
as  commanded  by  the  concern  whose  "going  value"  is 
to  be  appraised.  It  does  not  seem  to  the  writer  any 
simpler  or  more  satisfactory  to  thus,  on  the  judgment 
of  the  expert,  make  an  assumption  of  the  time  that 
would  be  required  to  establish  a  business  than  it  would 
be  on  the  basis  of  actual  experience  in  the  same  line 
of  business,  in  the  locality  involved  and  elsewhere,  to 
form  an  opinion  as  to  what  would  be  a  proper  allow- 
ance for  the  cost  of  development. 

In  any  business  which  is  already  established,  an 
analysis  may  be  desirable  of  the  various  elements  that 
make  up  the  intangible  values  of  the  property.  In  such 
cases  some  such  procedure  as  that  of  estimating  the 
cost  of  re-establishing  the  business  under  present  day 
conditions  may  be  of  service  in  segregating  "going 
value."  But  when  earnings  are  to  result  from  rates 
yet  to  be  fixed  the  case  is  somewhat  different,  and  the 
question  will  arise  whether  the  relation  between  cost 
of  development  actual  or  hypothetical,  however  ascer- 
tained, is  a  safe  guide  to  the  going  value  which  should 
be  created  by  the  profits  of  the  business  in  excess  of 
interest  on  the  invested  capital. 

Intangible  values  of  whatsoever  nature  result  from 
high  earnings.  They  include  not  only  "going  value," 
but  also  in  some  cases  water-right  values  and  what- 
ever may  be  included  in  such  terms  as  "franchise  val- 
ue," "good  will,"  and  the  like.  Such  values  do  not 
exist  unless  the  rates  are  higher,  as  the  writer  has  else- 
where pointed  out  they  should  be,  than  would  produce 
net  earnings  equaling  the  return  ordinarily  expected 
from  money  loaned  for  use  in  similar  enterprises. 

The  difficulty  of  using  a  hypothetical  reproduc- 
tion of  an  existing  utility  property,  as  a  means  of  es- 
timating the  cost  of  developing  the  business,  is  appa- 


ELEMENTS     DESERVING     CONSIDERATION        53 

rent  from  the  following  consideration.  The  compara- 
tive plant  is  assumed  to  be  exact  reproduction  of  the 
existing  plant.  There  is  no  competition  between  the 
two  plants.  It  might  be  assumed  that  the  moment  that 
the  comparative  plant  is  completed,  it  will  be  in  full 
service  at  the  same  earning  power  as  the  established 
plant.  There  would  then  be  no  appreciable  develop- 
ment period.  If  such  a  period  is  admitted  it  implies  a 
lack  of  completion  of  the  comparative  plant  or  the 
development  period  should  be  measured  only  by  the 
time  that  it  would  take  the  consumer  to  put  himself 
in  position  to  avail  himself  of  the  service.  The  market 
in  such  a  comparison  is  assumed  to  be  at  hand.  The 
expert  who  resorts  to  this  method  of  estimating  going 
value  will  give  his  judgment  wide  latitude,  as  his  con- 
clusions are  not  apt  to  be  convincing. 

Cost  of  Establishing  Business  is  not  Going  Value 

It  is  well  to  bear  in  mind,  however,  that  if  a  com- 
munity which  is  served  by  a  public  utility  had  under- 
taken the  establishment  of  this  utility  as  a  public  en- 
terprise it  would  have  been  subject  to  the  same  and 
perhaps  greater  costs  in  developing  the  local  business 
than  the  costs  which  were  incurred  by  the  owner  of 
the  property.  The  losses  in  the  early  years,  on  the 
same  chances  that  there  would  be  loss,  would  have 
confronted  the  public  as  it  confronted  the  private  en- 
terprise. The  cost  of  establishing  business  is,  there- 
fore, an  element  apart  and  while  perhaps  in  some 
measure  and  under  a  multiplication  of  facts  relating  to 
many  enterprises,  the  cost  of  establishing  business 
may  be  some  guide  to  what  the  normal  going  value 
should  be,  it  will  be  more  logical  to  treat  this  cost 
either  as  a  part  of  the  capital  legitimately  in  the  enter- 
prise, or  taking  the  other  extreme,  as  a  business  loss 
to  be  amortized  out  of  earnings  within  a  reasonable 
time. 

While  the  cost  of  establishing  the  business,  includ- 
ing early  losses  and  expenditures  for  unsuccessful 
work  are  not  a  direct  measure  of  going  value,  they  are, 
nevertheless,  in  so  far  as  they  were  legitimate,  of  that 


54  PUBLIC     UTILITY    KATE     FIXING 

class  of  expenditures  which  should,  as  already  stated, 
come  back  to  the  owner  of  the  property  sooner  or  later. 
The  mere  knowledge  that  this  is  the  case,  or  the  prob- 
ability that  the  owner  will  some  time  recover  them, 
adds  value  to  the  property.  To  add  them  in  the  exact 
amount  shown  by  the  cost  records  in  any  particular 
case  would  not,  invariably,  be  a  fair  procedure.  The 
owner  who  builds  with  care  and  under  the  best  expert 
advice,  and  who  pushes  his  work  forward  as  rapidly 
as  the  market  to  be  served  will  justify,  and  who  enters 
immediately  upon  a  profitable  business  without  any 
lean  years,  is  entitled  to  a  reward  for  his  able  manage- 
ment and  the  success  of  his  enterprise.  The  "going 
concern  value"  of  a  plant  constructed  under  such  fa- 
vorable circumstances  is  as  great  as  the  "going  con- 
cern value"  of  other  plants  of  a  similar  character  but 
burdened  perhaps  with  large  expenditures  for  unsuc- 
cessful work  and  for  the  development  of  business. 

The  combined  experience  of  all  utilities  of  similar 
character  should  in  the  long  run  establish  the  addition 
which  should  be  made  to  the  earnings,  either  to  amor- 
tize a  fair  allowance  for  this  class  of  expenditures  in 
a  reasonable  time  or  to  provide  an  adequate  return 
thereon  if  treated  as  investment  or  as  an  increment 
of  the  value  of  the  going  concern.  In  the  light  of  this 
conclusion  it  would  not  be  fair  in  the  individual  case 
to  treat  all  losses  during  lean  years  and  all  unpro- 
ductive expenditures  during  the  constructive  period, 
such  as  water  tunnels  or  wells  that  produce  no  water, 
structures  that  fail  during  erection,  damage  by  fire 
and  flood,  earthquake  or  war,  as  additions  to  value  or 
as  additions  to  a  rate-base.  These  are  losses  and  if 
occurring  after  operation  has  commenced  are  naturally 
treated  as  the  reverse  of  earnings.  They  cannot  with 
propriety  be  added  to  the  valuation  of  the  physical 
properties,  though  it  may  be  eminently  proper  on  ac- 
count thereof  to  estimate  the  cost,  of  reproduction  lib- 
erally. In  some  form  they  should  be  taken  into  ac- 
count in  fixing  rates.  It  is  rarely  practicable  to  deter- 
mine such  losses  and  unproductive  expenditures  with 
accuracy.  These  expenditures  and  losses  may  be  large 


ELEMENTS     DESERVING    CONSIDERATION       55 

and  yet  they  should  ordinarily  be  assumed  to  have 
been  incurred  under  competent  advice.  It  should  gen- 
erally be  assumed,  in  other  words,  that  it  could  not  be 
foreseen  that  what  turned  out  to  be  unproductive 
work  would  have  no  value.  The  easy  way  to  deal  with 
such  expenditures  is  to  add  them  to  the  rate-base  valu- 
ation, giving  them  a  name  and  treating  them  as  a 
measure,  in  part  at  least,  of  intangible  values.  While 
this  may  appear  reasonable  when  the  amount  involved 
is  small,  or  not  beyond  what  the  sum  of  human  experi- 
ence would  seem  to  indicate  as  fair,  the  other  case  can 
readily  be  foreseen,  as  already  explained,  in  which  this 
would  not  be  so.  To  lay  down  a  rule  that  actual  losses 
whether  during  construction  or  in  the  early  years  of 
operation,  are  to  be  treated  as  elements  of  value  is 
never  logical. 

It  should  be  noted,  too,  that  there  is  a  clear  dis- 
tinction to  be  made  between  the  expenses  ordinarily 
classed  as  "overhead"  and  "development  cost."  The 
overhead  expense  is  an  expense  incurred  during  con- 
struction and  is  naturally  and  logically  made  a  part  of 
the  cost  of  construction.  The  development  cost  is  an 
additional  outlay  during  operation,  which  is  necessary 
to  maintain  and  operate  the  property  during  the  time 
wrhen  the  receipts  for  commodity  furnished  or  for  serv- 
ice rendered  are  insufficient  to  meet  operating  ex- 
penses and  a  fair  interest  return  on  the  invested  capi- 
tal. 

Going  Value  the  Result  of  Earnings 

It  is  apparent  from  what  has  above  been  stated 
that  "going  value"  and  the  value  of  physical  elements 
are  elements  apart ;  between  which,  in  other  words, 
there  is  no  definite  relation.  "Going  value"  then  is 
not  dependent  upon  the  capital  which  is  invested  in 
any  property.  And  yet  "going  value"  grows  with  the 
business  enterprise.  It  is  subject  to  appreciation.  This 
suggests  that  when  once  the  going  value  is  determined 
which  efficiently  managed  enterprises  of  various  kinds 
should  ordinarily  have,  this  value  can  be  brought  into 
some  relation  to  the  volume  of  business.  This  thought 


56  PUBLIC     UTILITY    RATE    FIXING 

has  heretofore  been  advanced  by  the  writer  and  by 
others  who  are  contending  that  it  would  be  fair  to 
allow  a  going  value  about  equal  to  one  year's  income 
to  be  created  by  adequate  earnings.  On  this  point  Mr. 
Leonard  Metcalf,  a  consulting  engineer  of  large  ex- 
perience in  valuation  matters,  in  the  recent  Spring 
Valley  Water  Company  rate  case,  said : 

"In  terms  of  gross  annual  revenue,  development  expense 
is  found  to  be  approximately  equal  to  one  year's  gross  revenue 
as  of  the  date  of  valuation,  in  the  case  of  ordinary  water- 
works properties  of  medium  and  small  size,  and  between  one 
and  one  and  one-quarter  times  the  gross  annual  revenue  in  the 
case  of  the  larger  properties — the  cumulative  interest  during 
construction  charges  incident  to  the  long  period  of  construc- 
tion involved  in  the  building  of  the  larger  works  being  ac- 
countable for  the  difference." 

Bearing  on  this  same  subject  the  writer  in  a 
paper  read  in  1912  before  the  American  Society  of  Civil 
Engineers,  said : 

"The  most  logical  course  to  be  pursued,  and  the  one 
which  is  always  open  to  the  appraiser"  (rate-fixing  authority) 
"is  to  use  the  best  available  means  for  determining  the 
amount  of  capital  which  is  properly  invested,  then  to  deter- 
mine what  the  earnings  should  be  to  yield  an  ordinary  return 
on  the  investment  thus  ascertained,  and  then  to  increase  these 
earnings  by  an  arbitrary"  (reasonable)  "amount,  which  may 
vary  within  wide  limits,  not  only  to  compensate  for  past 
losses  and  for  the  hazard  during  construction  and  operation, 
but  also  as  a  compensation  for  management."  And  again: 
"Any  addition  to  the  rate  of  return  *  *  *  *  if  there  is 
certainty  that  it  will  be  earned,  is  the  real  basis  for  the  in- 
tangible values  as  they  would  be  taken  into  consideration  by 
a  purchaser." 

Along  the  same  line  of  reasoning  Mr.  Allen  Ha- 
zen,  also  of  the  highest  standing  among  consulting 
engineers  who  have  devoted  attention  to  valuation 
matters,  in  the  rate  case  already  referred  to,  says : 

"When  a  business  is  established  and  going  and  earning 
a  certain  revenue,  it  is  normally  worth  to  the  investor  what 
that  income  amounts  to,  capitalized  on  a  rate  of  return  on 
other  investments  of  equal  security,  and  that  the  rate  of  re- 
turn is  normally  less  than  the  amount  which  a  company  has 
to  have  the  chance  of  earning,  if  it  can,  in  order  to  induce 


ELEMENTS     DESERVING     CONSIDERATION        57 

capital  to  go  into  an  enterprise  of  that  kind;  in  other  words, 
if  you  want  to  build  the  Calaveras  works,  and  you  want  peo- 
ple to  put  their  money  into  the  enterprise  on  a  chance  of 
earning  some  rate  of  return  without  any  guarantee  that  they 
will  earn  it — simply  on  a  chance — we  have  to  make  that  chance 
7  per  cent,  we  will  say.  Now,  when  the  Calaveras  works  are 
built,  and  if  the  enterprise  is  successful  and  it  earns  that 
7  per  cent  on  what  it  has  cost,  and  is  established,  then  the 
man  on  the  street  will  capitalize  that  income  at  6  per  cent 
and  the  plant  is  worth  one-sixth  more  than  it  cost.'' 

The  Master  in  Chancery  in  this  case  upon  review- 
ing the  testimony  of  Mr.  Hazen,  of  which  the  above 
is  but  a  brief  extract,  then  goes  on  to  show  what  go- 
ing value  Would  be  created  if  various  rates  of  return 
appropriate  for  a  going  plant  and  a  like  plant  ready 
to  begin  business  were  assumed.  It  is  with  some  sat- 
isfaction that  the  writer  makes  note  of  these  facts 
and  of  the  endeavors  by  others  to  lay  a  basis  in  the 
earnings  for  "going  value,"  because  they  confirm  his 
conclusions  that  this  basis  lies  there  and  that  the  re- 
sult of  the  capitalization  of  the  earnings  should  not 
make  its  appearance  in  the  rate-base.  (See  preceding 
chapter.) 

May  we  not  conclude  then,  that  in  the  case  of 
the  public  utility  which  is  subject  to  regulation,  its  in- 
tangible values  arise  from  some  allowance  in  the  earn- 
ings, in  excess  by  some  predetermined  amount  of  the 
earnings,  which  would  just  yield  a  proper  rate  of  in- 
terest on  the  actual  capital  reasonably  and  properly 
invested.  When  the  sum  of  all  intangible  values  is 
thus  determined  (by  capitalization  of  a  part  of  the 
earnings)  it  will  matter  little  what  name  is  used  to 
designate  them.  But  the  increment  of  earnings  in  ex- 
cess of  the  ordinary  interest  rate  on  investments,  in 
safe  going  concerns,  should  be  so  fixed  to  cover  also 
any  amortization  made  necessary  by  obsolescence,  or 
loss  by  fortuitous  events,  and  to  cover  whatever  allow- 
ance is  to  be  made  as  compensation  for  management 
and  as  a  share  in  general  prosperity,  possibly  in  lieu 
of  appreciation.  When  the  limitation  of  this  excess 
by  rate  fixing  authorities  is  under  consideration,  it  can 
probably  be  more  nearly  standardized  by  bringing  it 


68  PUBLIC    UTILITY    RATE    FIXING 

into  some  definite  relation  to  volume  of  business,  than 
in  any  other  way.* 

*See  "Public  Utility  Rates  and  the  Volume  of  Business," 
page  46. 


LAND    ADAPTED     TO     SPECIAL    USE  59 


CHAPTER  III 

APPRAISAL  OF  REAL  ESTATE  ADAPTED  TO 
SPECIAL  USE 

The  Value  of  Reservoir  Lands 

No  definite  solution  of  the  problem  how  to 
determine  the  value  of  reservoir  property  has  yet  been 
devised.  There  is,  in  fact,  no  recognized  rule  by  which 
the  market  value  of  any  property  which  has  peculiar 
adaptability  for  some  particular  use  can  be  determined. 
No  other  course  is  open  in  ascertaining  the  value  of 
such  property  than  to  determine  the  effect  upon  the 
market  of  a  knowledge  of  all  the  circumstances  bear- 
ing upon  each  case. 

Circumstances  Affecting  the  Value  of  Land 

Speaking  generally  of  the  value  of  real  estate,  it 
may  be  said  that  the  effect  of  all  factors  which  influ- 
ence its  market  value  is  reflected  in  the  valuations 
made  from  time  to  time  by  experts,  and  by  the  courts 
or  other  public  authority,  and  also  by  the  sales  of 
which  knowledge  is  obtainable.  The  essential  element 
of  rental  value  or  productiveness  will  be  presently 
referred  to.  As  the  previous  valuations  and  records 
of  sales  of  similar  property  do  not  apply  to  the  time 
at  which  the  valuation  is  being  made,  some  attention 
must  be  given  to  the  rate  at  which  the  value  of  real 
estate,  expressed  in  terms  of  money,  has  been  ad- 
vancing. For  the  region  on  both  sides  of  the  south 
arm  of  San  Francisco  Bay  such  a  study  has  been  made 
and  the  results  thereof  are  hereinafter  presented.  This 
study  has  been  extended  to  five  of  the  bay  counties 
and  to  the  entire  State  of  California  and  covers  not 
alone  the  rates  at  which  real  estate  values  have  been 
increasing  but  also  the  rate  of  population  growth. 

As  population  increases  the  uses  to  which  land 
can  be  put  with  profit  are  advanced  from  lower  to 
higher  uses.  The  value  of  land  will  go  up  as  the 


60 

demand  for  its  higher  use  becomes  more  insistent.  If 
any  tract  of  land  taken  at  random  be  considered,  its 
value  will  go  up  in  some  relation  to  the  increasing 
density  of  population  in  its  vicinity.  The  more  remote 
that  it  is  from  a  population  center  and  the  smaller  the 
demand  of  society  that  it  be  put  to  beneficial  use,  the 
more  difficult  will  it  usually  be  to  trace  the  effect  of 
the  growth  of  population  on  its  value.  For  a  time  the 
supply  of  land  on  the  frontier  is  so  large  that  the 
value  thereof  may  not  be  determinable  from  the  return 
that  can  be  realized  by  using  it  in  any  particular  way. 
But  even  in  the  case  of  the  frontier  land  it  will  be 
found  that  as  the  demand  of  society  for  the  beneficial 
use  thereof  increases  its  value  will  increase.  When 
the  time  can  be  forecast  with  some  degree  of  certainty, 
at  which  the  land  will  be  in  demand  for  any  particular 
use,  the  basis  for  estimating  value  begins  to  assume 
definiteness.  When  finally,  under  use  for  certain 
purposes,  the  land  can  be  depended  upon  to  produce 
income,  the  basis  of  its  value,  in  part  at  least,  becomes 
positive.  It  may,  nevertheless,  still  continue  to  have 
more  or  less  speculative  value  due  to  its  proximate 
requirement  for  higher  uses. 

Ordinarily  when  the  value  of  land  is  in  question, 
the  return  which  the  land  produces  in  rents  or  other- 
wise, or  the  return  which  it  may  reasonably  be  hoped 
to  realize  in  the  future,  as  also  the  sales  of  other  sim- 
ilarly located  property  adapted  to  similar  uses  can  be 
used  as  guides  to  a  determination  of  market  value. 
The  actual  sales  are  valuable,  if  there  have  been  any, 
because  they  furnish  more  or  less  dependable  evi- 
dence of  the  effect  of  all  known  circumstances  upon 
the  public  mind  in  the  matter  of  land  value.  But  when 
land  is  under  consideration  which  is  in  use  or  which 
is  available  for  use  as  a  storage  reservoir  there  is 
usually  no  such  index  of  market  value  which  can  be 
applied.  It  would  be  an  unusual  circumstance  to 
find  sales  of  recent  date  of  similar  property  that  would 
with  any  definiteness  demonstrate  the  market  value. 
Neither  is  the  rental  value  of  such  property  for  the 
reservoir  use  to  which  it  is  specially  suited,  ascertain- 


LAND     ADAPTED     TO     SPECIAL     USE  61 

able,  even  when  already  in  use,  because  actual  com- 
petitive demand  for  such  property  is  usually  out  of  the 
question  and  it  is  not  practicable  to  so  apportion  the 
net  return  of  the  water  supply  business  that  the 
amount  thereof  which  should  be  ascribed  to  the  use  of 
the  reservoir  lands  and  which  might  be  a  key  to  rental 
value  can  be  ascertained. 

Factors  to  be  Considered  in  Determining  Market 
Value  of  Reservoir  Land 

There  are,  nevertheless,  many  circumstances 
which,  when  properly  understood,  will  have  an  effect 
upon  the  market  value  of  reservoir  properties.  Such, 
for  example,  are  the  time  when  the  use  of  the  reser- 
voir site  in  question  will  be  a  necessity,  and  the  time 
when  the  water  supply  commanded  and  made  avail- 
able by  the  reservoir  will  be  in  full  use ;  also  the  exist- 
ence and  relative  availability  of  other  storage  sites  or 
other  sources  of  water ;  the  location  of  the  reservoir 
site  and  all  circumstances  affecting  the  cost  of  devel- 
oping the  storage  and  of  developing  the  water,  partic- 
ularly when  the  reservoir  site  is  not  yet  in  use  nor 
immediately  requisite;  also  the  extent  to  which  the 
availability  of  any  particular  site  has  been  demon- 
strated by  the  actual  construction  of  works  and  the 
impounding  of  water ;  the  quality  of  the  water,  and 
every  circumstance  relating  to  valuations  theretofore 
made  by  competent  authority  of  the  property  in  ques- 
tion or  of  other  like  properties,  whether  for  rate-fixing 
or  other  purposes. 

Consideration  should  therefore  be  given  : 

To  the  adaptability  of  the  site  for  use  as  a  reservoir. 

To  the  necessity  for  such  use  immediately  or  in  the  near 
future  and  to  the  continuance  of  such  use. 

To  the  fact  that  the  reservoir  lands  have  been  assem- 
bled in  one  holding. 

To  the  question  of  whether  or  not  the  serviceability  of 
the  reservoir  site  for  water  storage  has  been  demon- 
strated by  actual  use. 

To  the  cost  of  the  lands  and  their  increase  in  value 
since  the  time  of  purchase. 

To  the  valuations    of    these    and    other    reservoir    lands 


62  PUBLIC     UTILITY    RATE     FIXING 

heretofore  determined  or  ascertained  by  rate  fixing 
authorities  and  by  the  courts. 

To  the  service  rendered  or  to  be  rendered  in  the  matter 
of  the  amount  and  quality  of  the  water  and  the  ad- 
vantages or  disadvantages  of  the  location  of  the  res- 
ervoir site,  particularly  when  one  of  the  functions 
of  the  reservoir  is  to  safeguard  a  supply. 

None  of  these  factors  taken  separately  leads  to  a 
determination  of  value  which  could  be  accepted  with- 
out question.  Any  or  all  of  them  may  influence  a 
willing  seller  or  a  prudent  purchaser  in  determining 
the  sale  or  purchase  price  of  such  properties  and  they 
all,  therefore,  must  be  regarded  as  having  more  or  less 
effect  upon  market  value. 

Any  evidence  furnished  by  sales  of  similar  prop- 
erty should  be  carefully  examined  and  should  not. be 
too  heavily  weighted.  In  the  case  of  any  individual 
sale  there  may  have  been  lack  of  information  on  the 
part  of  the  seller  of  the  full  market  value  of  the  land 
or  the  sale  may  have  been  prompted  by  other  consid- 
erations than  the  price  obtained  for  it.  Consequently 
but  little  dependence  can  ordinarily  be  placed  on  any 
s:ngle  real  estate  transaction. 

It  is  the  multiplication  of  these  transactions  which 
makes  them,  presumptively  at  least,  an  index  of  the 
judgment  of  the  public  relating  to  market  value.  The 
fewer  the  number  of  transactions  and  the  greater  the 
uncertainty  relating  to  the  circumstances  in  each 
thereof,  the  less  dependable  will  any  such  index 
necessarily  be. 

The  elements  which  determine  the  utility  of  a 
reservoir  area  for  the  development  of  a  water  supply 
by  storage  are  in  the  main: 

1.  A   fairly  level  area  of  considerable  extent  enclosed 
or  nearly  enclosed  by  higher  land,  forming  a  basin  which  may 
have   an   outlet    and   possibly   in    addition   one   or  more   low 
places  or  secondary  outlets  in  the  surrounding  rim  land,  all 
of  which  can  be  closed  by  dams. 

2.  A  tributary  watershed  from  which  the  run-off  due  to 
snow  and  rainfall  is  sufficient  to  be  worth  while,  after  allow- 
ing for  evaporation  and  other  water  losses  from  the  reservoir. 


LAND     ADAPTED    TO     SPECIAL     USE  63 

3.  A  geologic  formation  such  that  the  construction  of 
the  necessary  dam  or  dams  is  feasible  and  water  losses  from 
the  reservoir  will  not  be  excessive. 

4.  A  location  and  topographic  configuration  such  that 
the  cost  of  structures  will  not  be  prohibitive. 

5.  A   market,   present,   or   prospective,   for    the   water 
supply  which  will  be  made  available. 

In  the  case  of  a  storage  reservoir  the  prime  pur- 
pose of  which  is  to  hold  a  supply  of  water  in  reserve, 
for  emergency  use,  and  whose  serviceability  as  a 
producer  of  water  is  secondary,  an  element  of  first 
importance  in  determining  its  utility  will  be  location 
in  reference  to  the  district  to  be  served  and  in  relation 
to  the  other  works  for  the  supply  of  the  district. 

The  function  of  the  storage  reservoir,  broadly 
stated,  is  to  bring  the  natural  flow  of  the  stream  which 
feeds  it  under  control,  so  as  to  make  better  utilization 
possible  and  to  reduce  waste.  Without  a  storage  res- 
ervoir the  limit  of  utilization  at  any  particular  time  is 
the  discharge  of  the  stream  at  that  time.  In  the 
vicinity  of  San  Francisco  stream  flow  fluctuates  within 
wide  limits.  Under  the  peculiar  climatic  conditions 
of  the  Pacific  Coast  the  stream  which  flashes  up  to  a 
large  discharge  and  flood  stages,  under  the  influence 
of  the  winter  rain  storms,  may  dwindle  to  insignif- 
icance in  the  long  dry  period  of  summer  or  in  the 
interval  between  the  intermittent  rains  of  the  winter 
months.  As  a  source  of  water  for  use  in  supplying 
the  needs  of  the  inhabitants  of  a  city,  such  streams  as 
those  controlled  by  reservoirs  in  the  San  Francisco 
bay  region  would  be  of  but  little  value  without  storage 
reservoirs.  Nevertheless,  in  any  strict  analysis  of 
the  service  rendered  by  a  reservoir  in  increasing  the 
water  supply  from  the  stream  which  feeds  it,  some 
account  should  be  taken  of  the  additional  amount  of 
water  (that  is  of  the  water  in  excess  of  that  obtain- 
able from  the  stream  in  its  natural  condition)  which 
the  reservoir  makes  available.  Under  California  con- 
ditions, in  the  Coast  Range  and  in  the  lower  portions 
of  the  Sierra  Nevada  this  is  frequently  the  entire 
possible  water  output,  because  without  storage  the 


64  PUBLIC     UTILITY    RATE     FIXING 

obtainable  dependable  continuous  supply  measured  by 
the  minimum  natural  flow  would  not  justify  utiliza- 
tion. 

It  is,  of  course,  different  when  water  is  required 
intermittently  and  in  coincidence,  or  nearly  so,  with 
the  natural  large  flow  in  the  stream  as  may  be  the 
case  when  water  is  used  for  irrigation.  Thus,  for 
example,  a  large  part  of  the  snow  which  falls  during 
the  winter  months  in  the  high  Sierra  Nevada  Moun- 
tains, melts  and  appears  in  the  stream  in  the  spring 
and  early  summer  months  at  the  very  time  when 
water  is  in  demand  for  irrigation.  When,  on  a  stream 
which  carries  this  water,  storage  is  provided,  there 
will  be  better  control  of  the  flow,  wastage  will  be 
reduced,  and  water  may  be  held  over  from  a  season  of 
abundant  run-off  to  another  in  which  the  natural  flow 
is  light,  but  the  condition  will  rarely  prevail  under 
which  the  storage  reservoir  could  be  given  credit  for 
the  entire  amount  of  irrigation  water  developed  and 
withdrawn  from  the  stream. 

The  utility  of  the  reservoir  in  such  a  case  is 
measured  by  the  improved  service  which  it  makes 
possible  and  by  the  reduction  in  the  amount  of  water 
that  without  the  reservoir  would  go  to  waste. 

In  view  of  the  conditions  as  they  prevail  in  the 
San  Francisco  Bay  region  the  comparison  of  storage 
reservoirs  here,  whose  water  is  used  to  supply  the 
needs  of  the  residents  of  cities,  can  best  be  made  on 
the  basis  of  the  water  output  or  yield  per  acre  of 
ground  covered  by  the  reservoir.  But  in  addition, 
other  factors,  such  as  the  amount  of  storage  per  acre 
of  reservoir,  and  the  location  of  the  reservoir  may  also 
require  attention  and,  of  course,  too,  the  suitability 
of  the  water  for  the  uses  to  which  it  is  to  be  applied. 

Attention  may  be  called  in  this  connection  to  the 
fact  that  there  may  be  reservoirs  of  so  large  an  extent 
that  their  value  per  acre  of  reservoir  surface  is  small. 
The  case  of  a  lake  may  readily  be  conceived  which 
has  a  large  surface  area  and  which  with  a  low,  perhaps 
inexpensive  dam,  will  store  a  large  amount  of  water. 
From  such  a  reservoir  the  loss  of  water  by  evapora- 


LAND     APPLIED     TO     SPECIAL     USE  65 

tion  will  be  relatively  large  and  it  may  well  be  that 
the  water  production  will  now  and  then  be  negative, 
that  is,  there  will  be  occasional  years  with  less  inflow 
into  the  lake  than  is  required  to  make  good  the  evapo- 
ration. As  an  extreme  example  of  this  kind,  Goose 
Lake,  in  the  northeasterly  corner  of  California  may  be 
cited.  For  more  than  a  half  century  there  has  been  no 
outflow  from  this  lake.  As  a  storage  basin  in  the 
ordinary  sense  this  lake  would  have  no  value.  Tulare 
Lake  is  another  example.  Occasionally  in  such  sea- 
sons as  1861-62  and  1867-68  the  lake  has  been  full  and 
during  a  series  of  years  when  at  or  near  a  full  stage, 
has  contributed  to  the  flow  of  San  Joaquin  River.  But 
some  forty  years  have  now  elapsed  since  there  has 
been  any  outflow  from  the  lake.  The  evaporation  from 
the  large  area  that  is  exposed  to  evaporation  when 
there  is  water  in  the  lake  offsets  the  inflow  in  ordinary 
years. 

To  make  the  lake  a  dependable  source  of  water 
provision  must  be  made  to  draw  down  its  water  to 
lower  levels,  thereby  reducing  the  water  surface  area 
and  decreasing  the  annual  evaporation. 

Other  examples  can  be  cited  of  lakes  which  are  of 
so  large  an  extent  that  their  value  as  storage  basins  is 
low  when  compared  with  other  reservoirs  of  the  same 
storage  capacity  but  of  less  surface  extent. 

There  may  be  instances,  too,  though  in  the  case  of 
storage  reservoirs  they  appear  as  exceptions  rather 
than  as  the  rule,  where  the  superior  function  of  the 
reservoir  is  to  hold  water  in  reserve  to  be  available  in 
case  of  accident  to  the  system  as  ordinarily  in  use. 
Under  such  circumstances  the  value  of  the  reservoir 
n  ay  not  depend  upon  its  water  production  but  rather 
upon  its  location  and  storage  capacity.  A  case  in 
point  is  Merced  Lake,  located  within  the  limits  of  San 
Francisco,  which  rendered  such  valuable  aid  as  an 
ample  emergency  source  of  water  in  1906,  during  the 
time  that,  as  the  result  of  the  earthquake  and  fire,  the 
main  lines  of  San  Francisco's  water  supply  were 
temporarily  out  of  commission.  Water  from  this  lake 
is  in  use  in  small  quantity,  about  3,000,000  gallons  per 


66  PUBLIC     UTILITY     RATE     FIXING 

day.  It  is  expected  that  this  use  will  cease  in  the  near 
future  when  an  additional  supply  of  water  is  brought 
across  the  Bay  from  the  Alameda  and  Calaveras  Creek 
systems.  As  an  emergency  source  of  water  the  lake 
will  thereafter  continue  to  have  value,  but  this  value 
can  not  be  brought  into  any  satisfactory  relation  with 
the  value  of  other  more  remote  storage  sites  on  the 
basis  of  water  production  or  utilization  which  for 
Lake  Merced  may  soon  be  so  small  as  to  be  negligible. 
Such  factors  as  these  are  among  those  to  be 
considered  when  the  water  production  from  reservoirs 
or  the  value  of  reservoir  land  is  to  be  determined. 

Appreciation  of  Land  Value 

The  value  of  reservoir  land  is  not  necessarily 
greater  than  the  value  of  the  same  land  for  other  uses. 
The  case  may  readily  be  conceived  where  alternative 
uses  will  create  values  in  excess  of  the  amount  which 
could  economically  be  invested  in  the  reservoir  prop- 
erty. Under  such  circumstances  either  the  necessity 
for  the  utilization  of  the  site  does  not  exist  because 
alternative  sites  are  available  or  the  water-works  sys- 
tem must  get  along  without  the  storage  which  the 
reservoir  would  have  afforded. 

The  problem  of  determining  the  market  value  of 
reservoir  lands  is  one  of  the  most  difficult  that  can  be 
presented  to  the  engineer.  The  question  is  not  what 
such  lands  may  be  worth  as  a  part  of  a  water-works 
system  and  how  great  the  sacrifice  which  an  owner  of 
such  water-works  would  make  rather  than  to  be  de- 
prived of  the  use  of  the  reservoir,  but  what  is  their 
value  in  the  hands  of  an  owner  not  in  the  water  supply 
business  as  determined  by  the  competition  for  their 
acquisition  that  would  exist  between  various  parties 
who  could  utilize  them  sooner  or  later  for  reservoir 
purposes.  The  problem  will  involve  the  weighing,  in 
each  case,  of  all  attendant  circumstances.  This  is  par- 
ticularly true  when,  as  in  the  case  of  the  Spring  Valley 
Water  Company's  reservoirs  on  the  San  Francisco 
peninsula,  the  sites  occupied  are  the  only  ones  of  their 
character  which  are  available  to  adequately  fulfill  their 
purpose. 


LAND     ADAPTED     TO     SPECIAL     USE  67 

When  the  reservoir  site  to  be  valued  is  not 
already  in  use  but  the  necessity  for  its  use  is  pressing, 
it  may  be  proper  to  determine  an  upper  limit  of  value 
by  comparison  with  the  next  most  available  source  ot 
supply.  But  any  limit  thus  ascertained  is  not  market 
value,  though  it  may  occasionally  be  the  measure  of 
what  the  party  desiring  to  use  the  reservoir  property 
can  afford  to  pay. 

Increasing  Land  Values  in  the  San  Francisco 
Bay  Region 

Referring  now  to  the  increasing  value  of  land  in 
the  San  Francisco  Bay  region,  the  statement  may  be 
repeated  that  land  taken  in  its  entirety  is  increasing 
in  value.  Values  are  increasing  not  alone  at  and  near 
population  centers  but  also  in  broad  zones  which  are 
more  or  less  directly  under  the  influence  of  these  popu- 
lation centers,  and,  in  fact,  wherever  population 
growth  and  the  resulting  modification  of  transporta- 
tion facilities,  by  rail,  by  water  or  on  improved  high- 
ways have  affected  or  are  likely  to  affect,  in  not  too 
remote  future,  the  use  to  which  the  land  can  profitably 
be  put. 

While  this  is  true  and  while  the  possibility  is 
recognized  of  developing  a  law  approximately  true, 
connecting  land  value,  measured  in  terms  of  money, 
with  population  or  regional  density  of  population, 
there  will  always  be  local  exceptions  to  any  such  law. 
There  may  be  localities  too,  where  the  change  due  to 
environment  will  be  from  a  higher  to  a  lower  use 
where  value  will  decrease  instead  of  following  the 
general  law  of  increase.  Furthermore,  regularity  in 
the  rate  at  which  land  values  advance  is  not  to  be 
expected.  A  long  continued,  well  defined  upward 
movement  in  land  values  has  repeatedly,  in  the  history 
of  this  country,  resulted  in  over-speculation,  creating 
temporary  unwarranted  or  fictitious  high  values  trom 
which  there  was  thereupon  a  recession  <>r  beyond 
which  there  would  be  no  further  advance  until,  in  the 
course  of  time,  due  to  all  the  factors  incident  to 


68 


PUBLIC     UTILITY    RATE     FIXING 


growth  of  population  and  the  demand  of  society  for 
fuller  utilization  still  higher  value  was  created. 


/7<r/a?-5<9  '" 


f*ec,ooo.mv 


COMPARISON  or  POPULATION 

AX,CJ3£D  faUJC  orfffAL  ESTATE 

J^JA/  f/?/9MC/sco  Covwrr 


Chart  showing  comparison  of  the  growth   of  population   with   the 
assessed  value  of  real  estate  in  San  Francisco  County 

To  determine  population  growth  and  the  increas- 
ing value  of  farm  lands  recourse  may  be  had  to  the 
statistics  collected  by  the  U.  S.  census  and  to  the  an- 
nual county  assessments.  The  facts  here  presented 
are  the  result  of  recent  studies.  Due  allowance  should 
be  made,  however,  for  human  frailty  and  the  vagaries 
of  the  various  assessors  and  statisticians  whose  judg- 
ment and  skill  are  reflected  in  the  available  reports. 
The  figures  as  presented  are  but  an  imperfect  guide 
to  what  has  taken  place  in  the  past  and  should  be  dis- 


LAND    APPLIED    TO     SPECIAL     USE 


69 


counted  somewhat  when  attempting  a  forecast  of  what 
will  take  place  in  the  future. 

Confirmation  of  the  increasing  value  of  land  gen- 
erally and  therefore  of  reservoir  sites  will  be  found 
also  in  the  fact  that  there  has  been  a  constantly  in- 
creasing density  of  population  in  the  Bay  region,  and 
a  corresponding  increase  in  the  demand  for  lands  such 


rtE*t.£jrAss* 
if* 


mye  Annual  Rate  of tocrmtMisi  for  Cent. 


'ffffff/l. 


Chart   showing   comparison   of  the   growth    of   population   with    the 
assessed   value   of   real  estate  in   San   Mateo   County 

as  those  in  the  various  reservoir  sites  of  this  region 
which  if  not  held  for  reservoir  use  would  be  available 
for  other  purposes. 

The  assessors'  records  of  valuation   for  taxation 
purposes  cover  the  lands  in  private  ownership.     Such 


70 


PUBLIC     UTILITY    RATE     FIXING 


records  as  have  been  published  and  have  been  accessi- 
ble do  not  give  the  assessment  of  improvements  sepa- 
rately from  the  land  prior  to  1900.  For  the  more 
recent  years,  however,  the  assessed  valuation  of  land, 
without  inclusion  of  improvements  could  be  noted  for 
some  of  the  counties. 


Chart   showing   comparison   of   the   growth    of  population    with    the 
assessed   value   of   real   estate   in   Santa   Clara   County 

It  appears  from  the  tables  and  diagrams  which 
have  been  prepared  showing  this  information  for  Cali- 
fornia, for  the  City  and  County  of  San  Francisco,  and 
for  the  counties  of  San  Mateo,  Santa  Clara,  Alameda 
and  Contra  Costa  that:  - 


LAND     ADAPTED     TO     SPECIAL     USE 


71 


During  the  40  years  following  1870  the  population  growth 
of  the  State  of  California  when  considered  by  ten  year  periods 
has  been  at  an  average  rate  per  decade  of  44%  or  about  3.7% 
per  year. 

The  population  growth  of  San  Francisco  has  been  about 
30%  per  decade  on  an  average  for  the  same  4  decades  or 
about  2.7%  per  year. 

The  population  growth  of  Alameda  county  in  the  same 
period  has  been  about  59%  per  decade  or  about  4.8%  per  year. 

The  population  growth  of  Santa  Clara  county  in  the 
same  40  years  has  been  about  34%  per  decade  or  about  3.0% 
per  year. 

The  population  growth  of  Contra  Costa  county  in  this 
period  has  been  about  39%  per  decade  or  about  3.2%  per  year. 

The  population  of  San  Mateo  county  has  increased  dur- 
ing the  40  years  under  consideration  between  3%  and  4% 
per  year.  During  the  20  years  1880  to  1900  the  population 
growth  in  this  county  was  only  between  1.5%  to  2%  per  year. 

The  population  of  California  and  of  each  of  the 
five  counties,  San  Francisco,  San  Mateo,  Santa  Clara, 
Alameda  and  Contra  Costa,  as  determined  by  the  U.  S. 
census  at  ten  year  intervals  since  1860  is  noted  in 
Table  1. 

TABLE    1. 

Population   of   California 
and    of   Counties    In   the    South    San    Francisco    Bay    Region 


Year      California 


San 


San 


Santa      Alameda       Contra 


Francisco       Mateo 


Clara 


Costa 


1850 

92,597 

1860 

379,994 

56.802 

3,214 

11,912 

8,927 

5,328 

1870 

560,247 

149,473 

6,635 

26,246 

24,237 

8,461 

1880 

864,694 

233.959 

8,669 

35,039 

62,976 

12,525 

1890 

1,213.398 

298,997 

10,087 

48,005 

93.864 

13,515 

1900 

1,485,053 

342.782 

12,094 

60,216 

130,197 

18,046 

1910 

2.377,549 

416,912 

26,585 

83,539 

246,131 

31,674 

TABLE    2 

Population    Growth 

California   and    South    Bay   Counties 

Increase    since    last    Census 


Decade     California 

San 

San 

Santa      Alamedf 

Francisco 

Mateo 

Clara 

Per 

Cent    in 

the    Decade 

1860-70 

47.4 

163.1 

106.4 

120.3 

171.5 

1870-80 

54.3 

56.5 

30.7 

33.5 

59.8 

1880-90 

40.3 

27.8 

16.4 

37.0 

49.0 

1890-00 

22.4 

14.6 

19.8 

25.4 

38.7 

1900-10 

60.1 

21.6 

119.8 

38.7 

89.0 

Per  Cent 

per  Annum 

1860-70 

4.0 

10.0 

7.5 

8  .  - 

10.5 

1870-80 

4.4 

4.5 

2.7 

2.9 

4.8 

1880-90 

3.4 

2.5 

1.5 

3.2 

4.1 

1890-00 

2.0 

1.4 

1.8 

2.3 

3.3 

1900-10 

4.8 

2.0 

8.2 

3.3 

6.6 

Contra 
Costa 

58.8 

48.0 

7.9 

33.5 


4.8 
4.0 
0.8 
3.0 
5.8 


72 


PUBLIC     UTILITY    RATE     FIXING 


TABLE  3 

Population   Growth 
California  and   South    Bay   Counties 

Mean  of  the  average  annual   percentage  rates  of  increase   in  the 
several    decades   since    1860 


1860-70 
1860-80 
1860-90 
1860-00 
1860-10 

1870-80 
1870-90 
1870-00 
1870-10 

1880-90 
1880-00 
1880-10 


California 

San 

Francisco 

4.0 

10.0 

4.2 

7.2 

3.9 

5.7 

3.5 

4.6 

3.7 

4.1 

4.4 

4.5 

3.9 

3.5 

3.3 

2.8 

3.7 

3.5 

3.4 

2.5 

2.7 

2.0 

3.4 

2.0 

San 
Mateo 
7.5 
5.1 
3.9 
3.4 
4.3 

2.7 
2.1 
2.0 
3.5 

1.5 
1.6 

3.8 


Santa 
Clara 
8.2 
5.5 
4.8 
4.1 
4.0 

2.9 
3.0 
2.8 
2.9 

3.2 
2.7 
2.9 


Alameda 

10.5 
7.6 
6.5 
5.7 
5.9 

4.8 
4.4 
4.1 

4.7 

4.1 
3.7 
4.6 


Contra 
Costa 
4.8 
4.4 
3.2 
3.1 
3.7 

4.0 
2.4 
2.6 
3.4 

0.8 
1.9 
3.2 


Avenge  Armutl  fat*  tffocwse  txPer  tent. 


/  v  v  •/  LAM&J  &±ue, 


lart   showing   comparison   of   the   growth    of   population   with    the 
assessed   value   of   real   estate   in   Contra   Costa  County 


LAND     APPLIED     TO     SPECIAL     USE 


73 


If  assessors'  valuations  for  taxation  purposes  be 
accepted  as  the  basis  (however  unsatisfactory  this  may 
be  for  individual  years)  for  determining  the  periodical 
increase  in  the  value  of  real  estate,  the  result  will  be 
as  shown  in  Table  4.  The  figures  representing  tax 
values  are  as  reported  by  the  several  county  assessors 
or  as  modified  by  the  State  Board  of  Equalization  and 
published  in  the  reports  of  the  State  Controller. 

TABLE   4 

Valuation  for  Taxation    Purposes 
San    Francisco    Bay    Counties 
Real  Estate  and  Improvements 
Year 


1860 
1870 
1880 
1890 
1900 
1910 
1915 


San 

San 

Santa 

Alameda 

Contra 

Francisco 

Mateo 

Clara 

Costa 

25,125,800 

996,400 

2,584,700 

2,290,700 

1,050,900 

75,146,000 

1,533,450 

8,733,900 

9,621,700 

1,903,900 

165,024,000 

5,520,800 

21,451,800 

40,314,500 

6,128,200 

235,362,000 

12,332,500 

45,852,600 

69,649,500 

12.049,700 

288,531,000 

11,902,400 

46,027,100 

75,028,100 

11,660,100 

433,263,000 

24,569,000 

64,399,000 

174,099,000 

24,572,500 

470,077,000 

28,267,000 

65,885,000 

207,447,000 

Real  Estate  exclusive  of  improvements 


1900 
1901 
1902 
1903 
1904 
1905 
1906 
1907 
1908 
1909 
1910 
1911 
1912 
1913 
1914 
1915 

In  Table  S  comparisons  are  made  between  the 
rate  at  which  population  is  increasing  in  the  bay  coun- 
ties with  the  rate  at  which  the  taxation  value  of  real 
estate  is  increasing. 

TABLE    5 

Comparison   of  the    Rate   of    Population    Growth    with    the    rate   of 

increase  of  the  Valuation  of  Real  Estate  for  taxation  purposes 

San    Francisco    Bay   Counties 


190,457,000 

8,503,000 

32,130,000 

47,856,000 

8,777,850 

192,447,200 

8,554,000 

191,804,500 

8,633,000 

31,894,500 

50,006,000 

201,508,000 

9,970,000 

293,500,000 

10,360,000 

33,657,000 

56,516,000 

304,136,185 

10,917,000 

237,083,000 

11,981,000 

35,199,500 

61,526,500 

260,689,800 

15,322,000 

258,651,000 

16,542,000 

37,620,500 

106,901,500 

283,169,000 

17,256,500 

42,285,000 

120,278,000 

288,095,452 

17,413,000 

44.478,000 

110,964,000 

288.653.700 

19,020,000 

42,969,000 

110,309,000 

19,669,300 

323,715,060 

19,293,000 

42,877,000 

131,675,000 

17,217,000 

326,305,105 

19,600.000 

326,057,234 

19,979,220 

43,041,000 

146,022,000 

327.409,000 

Average 
Period    San  Francisco 

increase   per  year   in    percentage 
San  Mateo  Santa  Clara  Alameda 

Cont.  Costa 

Tax 

Tax 

Tax 

Tax 

Tax 

Popul. 

Val. 

Pop 

Val. 

Po 

P- 

Val. 

Pop. 

Val. 

Pop. 

Val. 

1860-70 

10.0 

11.6 

7.5 

4.5 

8. 

2 

13.0 

10.5 

15.4 

4.8 

6.1 

1870-80 

4.5 

8.2 

2.7 

13.7 

2. 

9 

9.4 

4.8 

15.4 

4.0 

12.4 

1880-90 

2.5 

3.6 

1.5 

8.3 

3' 

2 

6.5 

4.1 

5.5 

0.8 

7.0 

1890-OH 

1.4 

*..  1 

1.8 

—0.3 

2 

3 

0 

3.3 

0.7 

3.0 

—0.3 

1900-10 

2.0 

4.2 

8.2 

7.5 

3. 

3 

3.3 

6.6 

8.8 

5.8 

7,7 

74 


PUBLIC     UTILITY    RATE     FIXING 


1870-80 

4.5 

8.2 

2.7 

13.7 

2.9 

9.4 

4.8 

15.4 

4.0 

12.4 

1870-90 

3.5 

5.9 

2.1 

11.0 

3.0 

7.9 

4.4 

10.4 

2.4 

9.7 

1870-00 

2.8 

4.6 

2.0 

7.2 

2.8 

5.3 

4.1 

7.2 

2.6 

6.4 

1870-10 

2.6 

4.5 

3.5 

7.3 

2.9 

4.8 

4.7 

7.6 

3.4 

6.7 

1880-90 

2.5 

3.6 

1.5 

8.3 

3.2 

6.5 

4.1 

5.5 

0.8 

7.0 

1880-00 

2.0 

2.8 

1.6 

4.0 

2.7 

3.2 

3.7 

3.1 

1.9 

3.3 

1880-10 

2.0 

3.3 

4.5 

5.2 

2.9 

3.2 

4.7 

5.0 

3.2 

4.8 

•/" 


Chart   showing   comparison   of  the   growth    of   population   with    the 
assessed    value    of   real    estate   in   Alameda   County 

The  valuations  in  the  foregoing  tables  cover  all 
the  real  estate  in  each  county.  A  more  rapid  increase 
of  value  at  the  population  centers  was  suspected  than 
throughout  the  farming  and  grazing  districts  of  the 
several  counties.  To  obtain  some  light  on  the  ques- 
tion of  whether  outside  lands,  lands  not  within  incor- 


LAND     ADAPTED     TO     SPECIAL     USE  75 

porated  areas,  were  increasing  at  the  average  county 
rate,  the  values  of  farm  lands  as  reported  by  the  U.  S. 
census  were  examined. 

These  values  bear  out  the  conclusion  that  the 
value  of  outside  real  estate  too  is  increasing  with  in- 
creasing population  and  generally  at  a  slightly  higher 
rate.  Without  including  in  this  statement  the  actual 
figures  of  farm  land  values  as  they  appear  in  the  census 
reports,  attention  is  called  to  the  diagrams  1  to  6  on 
which  these  farm  land  values  for  the  counties  San 
Mateo,  Santa  Clara,  Alameda  and  Contra  Costa,  and 
rates  at  which  their  value  is  increasing  are  shown  'n 
comparison  with  similar  information  relating  to  popu- 
lation and  the  taxation  value  of  all  real  estate  and 
improvements. 

Court  Decisions  on  Reservoir  Land  Value  in  the 
San  Francisco  Bay  Region 

The  opinions,  relating  to  the  value  of  reservoir 
land  in  the  San  Francisco  Bay  region,  which  have 
been  formed  and  which  have  been  submitted  to  much 
discussion  may  not  always  have  had  their  origin  in 
sound  reasoning.  This  is  not  to  be  wondered  at  in 
view  of  the  difficulties  which  have  been  pointed  out. 
But  in  the  course  of  time  the  values  have  become  more 
and  more  clearly  defined  as  will  appear  from  a  consid- 
eration of  the  report  of  the  Standing  Master  in  Chan- 
cery, Mr.  II.  M.  Wright,  in  the  case  of  the  Spring 
Valley  Water  Company  vs.  City  and  County  of  San 
PYancisco  which  was  recently  made  to  the  court. 
(August,  1917.) 

With  reference  to  the  336  acres  in  the  Merced 
Lakes  the  Master  finds  that  they  were  of  a  market 
value  of  .^336,000  or  .^lOOO  per  acre  during  all  the  years 
1007  to  191 5.  lie  says: 

"I  think  they  were  worth  that  in  1907  and  in  view  of 
their  future  partial  abandonment  as  described,  I  do  not 
believe  they  can  be  considered  as  increasing  in  value  during 
this  period." 

lie  also  says : 

"This  is  approximately  the  value  of  the  gullies  leading 
into  the  lakes.  In  other  words,  if  the  lakes  were  not  there, 


76  PUBLIC    UTILITY    RATE     FIXING 

and  their  sites  to  be  condemned,  the  land  would  resemble  and 
probably  be  no  worse  than  these  gullies.  To  thus  assume  no 
additional  value  for  reservoir  availability"  (referring  to  the 
appraisal  submitted  by  plaintiff)  "over  the  value  for  other 
uses  seems  fair  and  conservative." 

On  the  question  of  the  best  factors  that  bear  on 
the  determination  of  market  value  in  the  case  of  the 
reservoirs  on  the  San  Francisco  peninsula,  the  Master 
states  that  he  finds  his  judgment  relying  rather  on 
other  considerations  than  their  original  cost  and  he 
enumerates  as  the  factors  which  to  his  mind  were  most 
satisfactorily  determinative  of  market  value  in  1913 
and  other  years  concerned : 

"(1)  the  state  of  the  market  for  these  reservoir  lands 

"(2)  the  valuation  by  Judge  Farrington 

"(3)  prior  valuations  by  persons  in  authority  and 
others." 

The  valuation  by  Judge  E.  S.  Farrington,  here 
referred  to,  relates  to  the  findings  of  the  court  in  a 
prior  rate  case  in  which  the  valuation  applied  to  the 
year  1903. 

The  Master  comments  on  the  relative  value  of 
the  Merced  Lake  lands  and  the  peninsula  reservoirs 
as  follows : — 

"We  are  justified,  too,  in  bearing  in  mind  the  fact  that  the 
Merced  reservoirs  have  in  this  case  been  found  to  be  worth 
$1000  per  acre,  valued  on  the  basis  of  adjacent  land  of  similar 
character  and  without  any  increase  by  reason  of  availability 
for  special  uses.  By  reason  of  its  low  level,  its  limited  supply 
and  poorer  quality  of  water,  and  its  approaching  disuse  ex- 
cept for  emergencies,  its  value  is  necessarily  less  than  the 
principal  reservoirs  of  the  system;  on  the  other  hand,  proxim- 
ity to  valuable  lands  and  shortness  of  conduits  are  influences 
tending  to  raise  the  value.  It  may  well  be  that  these  counter- 
acting influences  may  properly  be  considered  in  balance. 
At  any  rate,  we  may  say  that  there  is  here  some  indication 
that  the  peninsular  reservoirs  are  worth  not  less  than  $1000 
per  acre." 

The  problem  of  the  valuation  of  the  reservoir 
lands  in  this  rate  case  is  thus  stated  by  the  Master: 

"Attacking  our  problem  directly,  what  was  the  state  of 
the  market  for  reservoir  lands  in  the  years  1907-15?  For  this 
purpose,  I  assume  that  the  reservoirs  were  not  in  existence, 


LAND    ADAPTED    TO     SPECIAL     USE  77 

that  the  reservoir  lands  were  in  private  hands  devoted  to 
other  uses  than  public  uses,  and,  to  meet  the  suggestions  of 
the  Supreme  Court  in  the  Sage  case,  and  of  the  English  Court 
in  the  Lucas  case,  that  condemnation  proceedings  had  not 
been  begun." 

The  Master  referring  to  the  three  peninsula  res- 
ervoirs, the  Pilarcitos,  the  San  Andreas  and  the  Crys- 
tal Springs  then  continues : 

"As  for  the  supply,  these  three  reservoirs  are  unique 
and  indispensable.  There  are  no  others  on  the  peninsula  or 
elsewhere  within  a  similar  distance  comparable  with  them. 
*  *  *» 

"To  assist  our  thinking  as  to  what  would  be  the  market 
value,  we  may  visualize  the  situation  as  being  one  of  sale 
from  a  private  owner  or  owners,  as  willing  sellers,  to  willing 
purchasers,  either  the  present  plaintiff,  the  city,  or  any  other 
person  that  may  be  concerned.  The  price  thus  arrived  at 
would  be  the  same  as  the  award  in  a  condemnation,  as  I  un- 
derstand the  law." 

The  Master  thereupon  refers  to  the  bartering  that 
might  take  place  and  to  the  fact  that  expert  witnesses 
might  be  consulted  and  then  says : 

"It  is  hard  to  conceive  that  they  would  be  far  apart  con- 
sidering the  presence  of  competition  unless  the  seller  endeav- 
ored to  obtain  a  prohibitive  or  monopoly  price.  Let  us  to 
avoid  that  assume  that  the  seller  took  Mr.  Grunsky's  judg- 
ment and  asked  $1400  per  acre;  and  that  nevertheless,  in 
view  of  the  absence  of  comparable  sales  or  demonstrable 
values,  their  minds  were  in  an  uncertain  state  as  to  market 
value  like  a  chemical  solution  needing  a  precipitant  to  induce 
crystallization.  I  think  without  doubt  Judge  Farrington's 
decision  and  Mr.  Grunsky's  prior  valuations  as  City  Engineer 
would  furnish  such  a  precipitant.  I  have  no  question  that 
the  parties  would  agree  that  the  starting  point  must  be  a 
value  of  $1000  per  acre  in  1903.  Where  the  whole  matter  is 
uncertain,  a  decision  of  the  question  by  one  in  authority  is 
usually  readily  received  by  the  human  mind  so  as  to  make  an 
end  of  thinking." 

After  some  further  discussion  of  facts  presented 
in  the  case  as  having  bearing  upon  the  value  of  reser- 
voir land  the  Master  deals  with  the  question  of  appre- 
ciation in  the  following  words: — 

"I  conclude,  therefore,  that  we  may  reasonably  start 
with  the  assumption  that  the  peninsular  reservoir  lands  were. 


78  PUBLIC     UTILITY     RATE     FIXING 

in  1903,  worth  $1000  per  acre,  Judge  Farrington's  figure.  Have 
they  appreciated  in  the  succeeding  ten  year  period,  and  if  so, 
at  what  rate?  It  is  clear  to  me  that  an  appreciation  has 
occurred.  The  importance  of  these  reservoirs  and  the  increas- 
ing demand  for  them,  the  increase  in  value  of  lands  of  an 
agricultural  character  throughout  the  state  and  the  especially 
marked  increase  in  San  Mateo  county,  all  indicate  in  a  broad 
way  that  they  may  be  considered  as  appreciating  in  value 
during  the  decade." 

After  having  thus  referred  to  the  marked  increase 
in  values  of  real  estate  of  all  kinds  with  special  refer- 
ence to  San  Mateo  county  within  which  the  reservoirs 
are  located  and  with  reference  to  the  farm  lands  of  the 
entire  state,  the  Master  cites  some  of  the  rates  of 
population  growth  and  appreciation  from  the  data 
submitted  by  the  writer  and  continues : 

"It  is  to  be  noted,  however,  that  in  the  matter  of  adjust- 
ing watershed  values  among  the  various  years  here  in  contro- 
versy, the  parties  have  themselves  stipulated  a  more  moderate 
rate  of  appreciation,  viz.,  100%  for  1912-13,  1913-14  and  1914- 
15;  95%  for  1911-12,  90%  for  1910-11,  and  85%  for  1907-8. 
1908-9  and  1909-10.  And  this  stipulation  was  expressly  ex- 
tended to  reservoir  lands.  There  is  lacking  any  stipulation 
concerning  the  years  between  1903  and  1907,  but  the  statistics 
noted  show  an  appreciation,  and  in  the  spirit  of  the  stipula- 
tion, it  is  fair  to  say  that  during  the  four  years  1903-06,  the 
values  of  the  reservoir  lands  remained  the  same  at  $1000  per 
acre,  and  that  this  value  was  80%  of  the  1913  value." 

The  values  as  determined  by  the  Master  according 
to  this  finding  range  from  $1000  per  acre  for  the 
years  1903-6  to  $1250  per  acre  for  the  years  1912-15. 
It  is  interesting  to  the  writer  to  note  that  the  annual 
appreciation  represented  by  these  values  is  about  3.3% 
and  that  starting  with  the  Judge  Farrington  value  of 
$1000  per  acre  in  1903.  the  value  at  this  rate  of  appre- 
ciation throughout  the  decade  would  have  been  $1360 
per  acre  in  1913,  which  is  but  slightly  below  the  ap- 
praisal as  made  for  that  year  by  the  writer. 

In  reference  to  the  San  Antonio  and  Yalle  reser- 
voir sites  on  the  Alameda  Creek  system,  where  but 
small  increase  of  value  due  to  possible  future  use  as 
reservoirs  was  claimed,  the  Master  made  no  addition 
to  the  value  for  other  uses,  preferring  to  accept  the 


LAND     APPLIED     TO     SPECIAL     USE  79 

lower  value  as  a  conservative  allowance.  The  amounts 
involved  as  additions,  under  valuation  as  reservoir 
sites,  are  only  $8000  to  $12,000  in  the  case  of  the  San 
Antonio  and  $4000  to  $5000  in  the  case  of  the  Valle 
site. 

At  Calaveras,  too,  the  accepted  valuation  was  that 
made  on  the  basis  of  uses  other  than  as  a  reservoir. 
In  1913  work  on  the  Calaveras  dam  had  commenced 
but  the  reservoir  was  not  yet  in  use.  The  Master  says: 

"If  this  were  a  sale  or  a  condemnation,  as  of  1913,  I 
should  adopt  a  figure  at  least  equal  to  Mr.  Grunsky's  ($200 
per  acre).  The  question  is  whether  it  is  valued,  in  rate-fixing 
proceedings,  with  reference  to  its  actual  use  as  watershed, 
or  with  reference  to  its  potential  and  approaching  use  as  res- 
ervoir. In  the  1903  case  Judge  Farrington  discussed  this 
matter  and  valued  the  land  as  watershed  only." 

The  valuation  of  the  writer  referred  to  in  this 
quotation  is  about  twice  the  value  placed  upon  the 
land  by  other  experts  appearing  for  the  plaintiff  who 
gave  consideration  only  to  uses  other  than  reservoir 
use. 

Farther  along  in  his  report  the  Master,  after  stat- 
ing that  Judge  Farrington  was  right  in  omitting  the 
exploration  work  at  Calaveras  from  the  capital  in  use 
in  1903,  says  that  both  common  sense  and  authority 
requires  the  inclusion  of  these  expenditures  in  the 
years  beginning  with  1910  when  work  on  the  dam 
began  to  be  prosecuted  quite  actively.  He  then  con- 
tinues : 

"This  result  is  not  consistent  with  my  treatment  of  the 
Calaveras  reservoir  lands.  Those  lands  were  not  appraised 
at  their  full  market  value,  considering  their  availability  for 
reservoirs,  but  as  farm  lands  only.  This  case  has  been  con- 
sidered in  subdivisions  throughout  a  period  of  over  six  months, 
and  the  report  written  as  the  parts  were  decided.  The  prin- 
ciple applied  to  the  dam  was  appreciated  then,  as  the  lan- 
guage shows,  but  for  reasons  then  appearing  to  me  sufficient, 
and  not  now  clearly  in  mind,  the  additional  value  of  something 
over  $200,000  was  not  considered.  After  all  it  is  the  final 
result  that  is  important,  and  I  do  not  now  deem  it  necessary 
to  go  through  the  necessary  recomputations  and  rewrite  that 
portion  of  the  report." 


80  PUBLIC     UTILITY     RATE     FIXING 

When,  in  other  words,  according  to  this  conclu- 
sion, the  time  has  come  when  the  use  of  a  reservoir 
site  can  no  longer  be  postponed,  it  would  appear 
proper  to  recognize  that  its  market  value  is  not  neces- 
sarily determined  by  ordinary  uses  but  rather  by  its 
special  adaptability  to  store  water. 

It  has  not  been  made  clear  why  when  market 
value  is  under  consideration  this  should  not  apply  at 
all  times.  The  fact  that  a  tract  of  land  by  reason  of 
topographic  features  is  suitable  for  use  as  a  reservoir 
and  will  some  day  be  converted  into  a  reservoir  is  an 
element  of  value.  The  addition  of  value  due  to  pos- 
sible reservoir  use  may  be  trifling  when  the  time  of 
such  special  use  is  remote  and  difficult  to  forecast.  It 
will  become  more  definite  and  material  the  nearer  the 
time  approaches  when  such  use  will  be  a  necessity. 
But  there  is  in  the  case  of  the  reservoir  not  yet  in 
service,  always  the  other  question  to  be  considered 
whether  or  not  the  property  is  a  useful  member  of  the 
water-supply  system  and  whether  if  useful,  for  exam- 
ple, as  a  watershed  any  necessity  of  holding  it  as  a 
reservoir  site  can  be  shown.  Should  not  the  higher 
reservoir  value  as  part  of  the  rate-base  date  from  the 
time  that  the  property  goes  into  use  as  a  reservoir? 
This  is  apparently  the  view  accepted  both  by  Judge 
Farrington  and  the  Master,  Mr.  Wright. 


MARKET     VALUE     OF     LAND  81 


CHAPTER  IV 

DETERMINATION   OF  THE   VALUE   OF  REAL 

ESTATE    IN    EMINENT   DOMAIN 

PROCEEDINGS 

All  possible  Uses  Must  Be  Considered 

While  the  writer  can  not  accept  as  final  the 
apparent  requirement  of  the  courts  that  value  of  the 
property  used  and  useful  is  the  proper  basis  of  the 
calculation  when  the  earnings  of  a  public  utility  are 
to  be  fixed  by  regulation,  he  can  not  but  admit  that 
until  there  is  a  reversal  of  the  attitude  of  the  courts 
this  requirement  must  be  complied  with  and  that, 
therefore,  when  the  value  of  land  is  under  consider- 
ation in  a  rate  case  the  same  principles  of  valuation 
must  control  as  in  the  case  of  a  sale  or  of  condemna- 
tion proceedings. 

The  fact  seems  to  be  well  established  that  when 
land  is  required  for  some  purpose  for  which  it  may  be 
taken  under  eminent  domain  proceedings,  the  inquiry 
must  be  directed  to  market  value  with  due  regard  to 
every  use  for  which  the  land  is  suitable.  The  question 
is  not  what  the  purchaser  can  afford  to  pay  in  view  of 
the  special  purpose  for  which  he  wants  the  land  but 
Avhat  in  view  of  the  land's  adaptability  for  this  to- 
gether with  all  other  possible  uses  it  would  bring  in 
the  market  under  the  assumption  of  competition  for 
its  acquisition.  The  market  value  will  ordinarily  be 
determined  by  the  highest  use  to  which  the  land  can 
be  put,  and  in  view  of  this  fact  a  consideration  of  this 
highest  use  may  make  consideration  of  inferior  uses 
unnecessary  except  to  show  that  they  stand  low  in 
the  scale  and  that  their  exclusion  from  consideration 
will  not  affect  market  value. 

Sometimes  of  course  the  adaptability  of  a  tract 
of  land  for  a  high  use  is  recognized  but  the  demand  of 
society  that  it  be  put  to  that  use  lies  in  the  future. 


82  PUBLIC    UTILITY    RATE    FIXING 

While  the  land  is,  perhaps,  peculiarly  adapted  for  some 
special  purpose,  for  example  to  serve  as  a  light  house 
site  or  under  improved  transportation  conditions  as 
a  quarry  or  as  a  reservoir  site,  the  demand  for  such 
use  may  not  be  made  immediately.  Nevertheless  the 
probability  or  the  certainty  that  the  land  will  be  re- 
quired for  some  specific  purpose  at  some  time  in  the 
future,  and  that  when  the  necessity  for  such  use 
actually  arises,  its  value  will  be  greater  than  for  any 
other  uses  to  which  it  can  be  put,  may  be  an  element 
of  potential  value.  In  such  circumstances  a  market 
value  higher  than  that  determined  for  other  similar 
land  not  having  the  adaptability  for  the  special  use 
will  be  the  more  difficult  to  recognize  the  farther  in 
the  future  and  the  more  uncertain  the  time  at  which 
the  necessity  will  arise  for  putting  the  land  to  the 
special  use. 

Reference  to  Court  Decisions 

On  the  subject  of  the  market  value  of  land  the 
U.  S.  Supreme  Court  in  Boom  Co.  vs.  Patterson  (98 
U.  S.  403,  408 ;  25  L.  Ed.,  206)  says : 

"The  inquiry  in  such  cases  must  be  what  is  the  property 
worth  in  the  market,  viewed  not  merely  with  reference  to  the 
uses  to  which  it  is  at  the  time  applied,  but  with  reference  to 
the  uses  to  which  it  is  plainly  adapted;  that  is  to  say,  what 
is  it  worth  from  its  availability  for  valuable  uses. 
Its  capability  of  being  thus  available  gives  it  a  market  value 
which  can  be  readily  estimated." 

In  this  case  the  Boom  Company  had  brought  suit 
in  Minnesota  against  Patterson,  a  citizen  of  Illinois, 
to  condemn  three  islands  which  were  desired  for  use 
in  connection  with  a  series  of  log  booms.  A  verdict 
was  rendered  by  the  jury  for  $9358.33,  the  value  of  the 
islands  having  been  found  to  be  $300,  aside  from  any 
consideration  of  value  for  boom  purposes  and  $9058.33 
due  to  their  adaptability  for  this  special  use.  The 
Court  granted  a  motion  for  a  new  trial  unless  the 
owner  would  consent  to  accept  $5500.  This  amount 
was  acceptable  to  the  owner  and  judgment  for  this 
amount  was  entered  in  his  favor.  The  Boom  Company 
then  appealed. 


MARKET    VALUE     OF     LAND  83 

The  Supreme  Court  is  perhaps  a  little  over- 
confident if  it  would  have  the  inference  drawn  from  the 
quoted  statement  that  market  value  of  land  can 
always  be  readily  estimated.  In  other  respects  the 
statement  is  clear  and  logical.  The  real  question  is, 
What  is  the  value  of  the  property  under  consideration 
of  all  uses  to  which  it  may  be  applied?  The  controlling 
factor  in  a  reply  to  this  question  will  generally  be  the 
value  determined  from  the  highest  uses.  Sometimes, 
of  course,  value  resulting  from  various  uses  may  be 
more  or  less  cumulative.  Thus,  for  example,  a  water- 
shed may  also  have  value  as  a  forest  and  an  artesian 
well  tract  while  used  as  a  source  of  water  may,  at  the 
same  time,  retain  its  value  as  farming  land. 

Value  in  the  sense  here  used  is  market  value  and 
must  not  be  mistaken  for  value  to  a  person  who  desires 
to  acquire  the  property  when  taken  in  the  sense  of 
what  such  person  can  afford  to  pay  for  it.  On  this 
subject  in  U.  S.  vs.  Chandler-Dunbar  Water  Power 
Company  (229  U.  S.  80)  the  U.  S.  Supreme  Court 
says: 

"In  condemnation  proceedings  the  value  of  the  property 
to  the  Government  for  its  particular  use  is  not  a  criterion. 
The  owner  must  be  compensated  for  what  is  taken  from  him, 
but  that  is  done  when  he  is  paid  its  fair  market  value  for  all 
available  uses  and  purposes." 

Referring  to  special  value  of  land  for  canal  and 
lock  purposes  in  this  same  case  the  Court  says : 

"The  exception  taken  to  the  inclusion  as  an  element  of 
value  of  the  availability  of  these  parcels  of  land  for  lock  and 
canal  purposes  must  be  overruled.  That  this  land  had  a  pros- 
pective value  for  the  purpose  of  constructing  a  canal  and 
lock  parallel  with  those  in  use  had  passed  beyond  the  region 
of  the  purely  conjectural  or  speculative.  That  one  or  more 
additional  parallel  canals  and  locks  would  be  needed  to  meet 
the  increasing  demands  of  lake  traffic  was  an  immediate 
probability.  This  land  was  the  only  land  available  for  the 
purpose." 

In  the  case  of  San  Diego  Land  and  Town  Co.  vs. 
George  Xeale  et  al  (78  Cal.  63,  68 ;  30  Pac.  Rep.  372 ; 
3  L.R.A.  372)  the  majority  of  the  State  Supreme 
Court  says  in  dealing  with  market  value  of  land: 


84  PUBLIC    UTILITY    RATE    FIXING 

"The  consensus  of  the  best  considered  cases  is  that  for 
the  purposes  in  hand  the  value  to  be  taken  is  the  market 
value,  by  which  is  undoubtedly  meant,  not  what  the  owner 
would  realize  at  a  forced  sale,  but  'the  price  that  he  could 
obtain  after  reasonable  and  ample  time,  such  as  would  ordi- 
narily be  taken  by  an  owner  to  make  sale  of  like  property.' 
.  But  in  many  instances,  as  in  the  case  before  us, 
there  is  no  actual  demand  or  current  rate  of  price,  either 
because  there  have  been  no  sales  of  similar  property,  or 
because  the  particular  piece  is  the  only  thing  of  its  kind  m 
the  neighborhood,  and  no  one  has  been  able  to  use  it  for  the 
purpose  for  which  it  is  suitable  and  for  which  it  may  be 
highly  profitable  to  use  it.  ...  From  the  necessity  of 
the  case  the  value  must  be  arrived  at  from  the  opinions  of 
well  informed  persons,  based  upon  the  purposes  for  which 
the  property  is  suitable.  .  .  .  What  is  done  is  merely  to 
take  into  consideration  the  purposes  for  which  the  property 
is  suitable,  as  a  means  of  ascertaining  what  reasonable  pur- 
chasers would  in  all  probability  be  willing  to  give  for  it, 
which,  in  a  general  sense,  may  be  said  to  be  the  market  value. 
And  in  such  an  inquiry  it  is  manifest  that  the  fact  that  the 
property  in  question  has  not  previously  been  used  for  the 
purposes  in  question  is  irrelevant.  The  current  of  authority 
sustains  these  views." 

There  is  but  little  to  add  to  a  statement  so  clear 
as  this.  If  the  land  is  not  already  in  use  for  the  pur- 
pose for  which  it  is  being  valued  but  the  time  can  be 
forecast  when  its  use  for  this  purpose  will  be  neces- 
sary, the  appraisal  should  be  made  with  this  fact  in 
mind. 

Concerning  the  admissibility  of  evidence  in  court 
proceedings  relating  to  value  of  land  for  some  special 
use  there  has  been  much  uncertainty  which  seems  to 
have  been  cleared  away  by  the  Supreme  Court  of 
California  in  the  comparatively  recent  case  of  "Sacra- 
mento Southern  Railroad  Co.  vs.  Heilbron"  (156  Cal. 
408)  which  involves  the  condemnation  of  a  strip  of 
land  for  railroad  purposes.  It  was  contended  in  this 
case  that  the  rule  as  laid  down  in  California  permits 
evidence  of  the  value  of  land  in  terms  of  money  when 
the  land  is  used  for  a  particular  purpose.  The  Court 

says: 

"It  is  seen,  therefore,  that  this  court  by  its  latest  utter- 
ances has  definitely  aligned  itself  with  the  great  majority  of 


MARKET    VALUE    OF    LAND  85 

the  courts  in  holding  that  damages  must  be  measured  by  the 
market  value  of  the  land  at  the  time  it  is  taken,  that  the  test 
is  not  the  value  for  a  special  purpose,  but  the  fair  market 
value  of  the  land  in  view  of  all  the  purposes  to  which  it  is 
naturally  adapted;  that,  therefore,  while  evidence  that  it  is 
'valuable'  for  this  or  that  or  another  purpose  may  always  be 
given  and  should  be  freely  received,  the  value  in  terms  of 
money,  the  price,  which  one  or  another,  witness  may  think 
the  land  would  bring  for  this  or  that  or  the  other  specific  pur- 
pose is  not  admissible  as  an  element  in  determining  market 
value." 

The  Court  here  apparently  intends  to  exclude  any 
evidence  relating  to  what  a  purchaser  could  afford  to 
pay  for  the  land  for  any  specific  purposes.  The  rule 
thus  laid  down  should  not,  however,  debar  from  con- 
sideration the  economic  features  of  an  enterprise  in 
connection  with  which  the  land  can  be  put  to  profitable 
use ;  but  the  question  to  be  answered  will  not  be  as 
already  stated  how  much  could  the  owners  or  pro- 
moters of  such  an  enterprise  afford  to  pay  for  the  land 
but  rather  what  effect  will  such  circumstances,  under 
the  assumption  of  competition,  have  upon  the  market 
value  of  the  land.  The  courts  must  and  do  exclude 
evidence  bearing  on  value  which  is  too  remote  or  spec- 
ulative in  character.  But  the  courts  will  be  interested 
in  the  same  facts  which  would  influence  a  prudent 
purchaser  who  before  making  an  offer  weighs  all  the 
facts  which  are  likely  in  any  way  to  affect  the  market 
value.  Special  adaptability  to  a  special  use  will  not 
be  overlooked,  due  allowance  will  be  made  for  risk,  for 
cost  of  preparation,  and  for  the  time  which  must 
elapse  before  a  return  can  be  realized  and  all  such  facts 
will  be  weighed  to  determine  what  in  the  light  thereof 
a  well  informed  public  would  consider  the  property 
worth. 

The  Value  Multiple 

In  the  case  of  land  which  is  required  for  railroad 
and  canal  rights  of  way,  the  problem  is  complicated  by 
the  fact  that  sales  of  property  for  such  purposes  are 
generally  so  rare  in  the  locality  where  a  valuation  is 
to  be  made  that  the  effect  of  use  for  this  special  pur- 
pose upon  market  value  is  not  readily  traceable.  The 


86  PUBLIC     UTILITY     RATE     FIXING 

owner  of  property  that  is  wanted  for  such  a  purpose 
may  benefit  by  the  proposed  improvement  which  is 
going  to  promote  general  prosperity  and  may  make 
the  remainder  of  his  holdings  available  for  uses  which 
are  out  of  the  question  before  the  improvement  is 
made.  But  in  this  respect  the  owner  is  no  better  or 
worse  off  than  his  neighbors  and  the  fact  that  he 
participates  in  the  general  benefit  is  no  reason  why  he 
should  not  get  full  market  value  for  what  is  taken 
from  him.  He  may  suffer  injury  far  beyond  that 
resulting  directly  from  the  taking  of  a  few  acres.  If  he 
were  allowed  the  value  acre  for  acre  of  adjacent  prop- 
erty or  value  for  other  uses  than  rights  of  way  he 
would  be  inadequately  compensated.  He  would  not 
have  recovered  full  market  value.  The  difficulty  of 
approximating  the  sacrifice  which  a  land  owner  makes 
when  he  gives  up  a  right-of-way  has  led  to  the  attempt 
to  estimate  this  in  relation  to  the  value  of  the  land  for 
ordinary  uses.  This  relation  is  expressed  by  the  so- 
called  'value  multiple.'  It  has,  thus,  become  a  practice 
to  value  rights-of-way  for  railroads  at  from  1.5  to  3.0 
times  the  market  value  of  lands  of  similar  character. 
Custom  has  given  land  required  for  such  a  use  such 
values.  Because  there  are  no  frequent  transfers  of 
land  for  right-of-way  use,  the  value  multiple  which  is 
found  to  be  generally  accepted  in  a  region  where  a 
right-of-way  is  to  be  valued  may  be  the  best  guide  in 
fixing  this  value. 

The  value  multiple,  as  applied  in  any  locality  to 
railroad  rights-of-way,  and  the  unit  price  per  pole  of 
a  power  line  are  the  outcome  of  numerous  adjustments 
resulting  from  considerations  as  here  indicated  and 
where  such  multiples  are  recognized,  they  will  have  an 
effect  upon  the  market  value  of  other  similar  ease- 
ments. 

On  this  subject  Justice  Hughes  in  the  Minnesota 
Rate  Cases  (230  U.S.  352;  33  Sup.  Ct.  729),  speaking 
for  the  U.  S.  Supreme  Court  says : 

"The  increase  sought  for  'railway  value'  in  these  cases 
is  an  increment  over  all  outlays  of  the  carrier  and  over  the 
values  of  similar  land  in  the  vicinity.  It  is  an  increment 


MARKET    VALUE     OF    LAND  87 

which  can  not  be  referred  to  any  known  criterion,  but  must 
rest  on  a  mere  expression  of  judgment  which  finds  no  proper 
test  or  standard  in  the  transactions  of  the  business  world. 
It  is  an  increment  which  in  the  last  analysis  must  rest  on  an 
estimate  of  the  value  of  the  railroad  use  as  compared  with 
other  business  uses,  it  involves  an  appreciation  of  the  return 
from  rates  (when  rates  themselves  are  in  dispute)  and  a 
sweeping  generalization  embracing  substantially  all  the  activ- 
ities of  the  community.  For  an  allowance  of  this  character 
there  is  no  warrant. 

"Assuming  that  the  company  is  entitled  to  a  reasonable 
share  in  the  general  prosperity  of  the  communities  which  it 
serves,  and  thus  to  attribute  to  its  property  an  increase  in 
value,  still  the  increase  so  allowed,  apart  from  any  improve- 
ments it  may  make,  cannot  properly  extend  beyond  the  fair 
average  of  the  normal  market  value  of  land  in  the  vicinity 
having  a  similar  character.  Otherwise  we  enter  into  the 
realm  of  mere  conjecture.  We,  therefore,  hold  that  it  was 
error  to  base  the  estimates  of  the  value  of  the  right-of-way, 
yards  and  terminals  upon  the  so-called  'railway  value'  of  the 
property.  The  company  would  certainly  have  no  ground  of 
complaint  if  it  were  allowed  a  value  for  these  lands  equal  to 
tue  fair  average  market  value  of  similar  land  in  the  vicinity, 
without  additions  by  the  use  of  multipliers,  or  otherwise,  to 
cover  hypothetical  outlays." 

It  seems  to  be  here  assumed  that  the  'railway 
value'  results  from  railway  use  and  from  the  earnings 
that  are  made  possible  by  such  use  and  the  Court  is 
unquestionably  right  in  stating  that  an  appreciation 
due  to  this  cause  is  not  allowable  when  rates  them- 
selves are  in  dispute.  Nevertheless  the  fact  remains 
that  the  general  use  of  value  multiples  in  any  locality 
is  a  factor  which  may  have  to  be  taken  into  account 
when  a  right-of-way  appraisal  is  to  be  made.  This 
fact  was  recognized  by  Special  Master  Thorington  in 
the  earlier  case  of  the  Georgia  Railway  Company  vs. 
Railroad  Commission  of  Alabama  (Jan.  8,  1912)  in 
which,  after  stating  that  the  fact  that  a  railroad  com- 
pany is  compelled  to  pay  in  addition  to  market  value 
as  would  be  determined  from  ordinary  uses,  a  further 
sum  due  to  damages  or  because  it  is  a  railroad  com- 
pany, adds  nothing  whatever  to  acreage  value,  he  says : 


88  PUBLIC    UTILITY    RATE    FIXING 

"It  is,  however,  proper  to  add  that  right-of-way  values 
including  estimates  for  damages  to  property  not  taken,  or 
excess  cost  that  railroads  are  compelled  to  pay  in  order  to 
acquire  right-of-way  property  needed  by  them  for  railroad 
use,  have  been  recognized  by  some  courts,  and  some  railroad 
commissions,  and  such  excess  cost  was  held  to  properly  con- 
stitute part  of  the  right-of-way  valuation  for  rate  purposes. 
In  Shephard  vs.  Northern  Pacific  Railway  Co.  et  al  (184  Fed. 
765)  it  is  said  the  evidence  was  conclusive  'that  every  rail- 
road company  is  compelled  to  pay  more  than  the  normal 
market  value  of  property  in  sales  between  private  parties  for 
the  irregular  tracts  it  needs  and  acquires  for  rights-of-way, 
yards  and  station  grounds.  .  .  .  The  measure  of  the  value 
of  real  estate  is  its  market  value  for  its  most  available  use.' " 

And  now  a  word  about  the  factors  which  must  be 
considered  when  an  appraisal  is  to  be  made  of  the 
value  of  real  estate  for  ordinary  and  not  special  use. 
Ordinarily  there  is  no  analysis  made  of  these  factors. 
The  judgment  of  the  public  as  the  same  has  found 
expression  in  other  sales  or  offerings  of  similar  prop- 
erty is  accepted  as  a  sufficiently  dependable  index. 
The  broad  rule  that  the  return  in  rents  or  net  income 
is  the  basis  of  value  may  find  application;  but  when  it 
is  applied,  some  regard  must  be  had  to  the  future  not 
alone  in  the  matter  of  the  actual  return  that  it  is 
reasonable  to  assume  but  also  in  the  matter  of  the 
effect  of  the  possible  rents  obtainable  upon  the  un- 
earned increment  or  the  added  value  that  will  result 
from  the  higher  uses  to  which  the  real  estate  will  be 
put  as  population  density  increases.  (See  the  earlier 
article  on  this  subject  on  the  Value  of  Reservoir  Lands 
in  San  Francisco  Bay  region.) 

Going  back  of  the  judgment  of  the  public  which 
fixes  the  market  value  it  is  evident  that  when  any  two 
tracts  of  land  are  compared  there  will  be  points  of 
difference  as  well  as  points  of  resemblance.  Thus,  for 
example,  if  two  tracts  of  agricultural  land  are  under 
consideration  the  tract  which  is  nearest  to  a  market 
(in  the  matter  of  cost  of  transportation)  will  have  an 
advantage  over  the  other.  Good  roads  which  make 
access  to  the  market  and  to  the  advantages  of  a  popu- 
lation center  easy,  lend  value  to  the  properties,  school 


MARKET    VALUE     OF     LAND  89 

facilities  also  add  value,  at  least  equal  under  ordinary 
conditions  to  what  the  acquisition  of  the  school  prop- 
erty has  cost  the  owner  of  the  land ;  so  too  irrigation 
systems,  drainage  works,  and  the  like,  as  well  as  the 
more  obvious  factors  relating  to  character  of  soil  and 
subsoil,  the  return  from  crops  that  can  be  profitably 
cultivated,  climate  and  environment.  The  menace 
from  hurricanes,  floods  and  other  fortuitous  events, 
too,  affects  the  desirability  of  ownership  and  therefore 
value.  That  it  will  be  difficult  to  evaluate  in  any  defi- 
nite way  these  factors  and  others  that  will  readily 
occur  to  an  appraiser  goes  without  saying.  Neverthe- 
less they  deserve  attention  and  the  hope  may  be 
expressed  that  with  reference  to  many  of  them  their 
relative  importance  at  least  in  establishing  market 
value  may  yet  be  found. 


90  PUBLIC    UTILITY    RATE    FIXING 

CHAPTER  V 
DEPRECIATION  AND  APPRECIATION 

The  Depreciation  Problem 

In  an  earlier  article  of  this  series  something  has 
already  been  said  about  depreciation  and  the  replace- 
ment requirement  and  about  the  consideration  that 
should  be  given  thereto  when  earnings  are  to  be  lim- 
ited by  regulation.  It  has  been  stated  by  the  author 
that  it  is  fundamentally  sound  in  principle  and  is  good 
practice  to  regard  the  public  utility  as  an  institution  or 
enterprise  which  has  unlimited  life  (except,  of  course, 
in  the  special  case  where  peculiar  circumstances  fix  a 
life  term)  and  that  so  regarded,  all  necessity  for  esti- 
mating accrued  depreciation  or  the  present  worth  of 
elements  of  limited  life  when  rates  are  to  be  fixed  falls 
away.  This  does  not  mean  that  maintenance  and  up- 
keep may  be  neglected.  On  the  contrary,  adequate  pro- 
vision must  always  be  made  to  meet  repairs  and  re- 
placements regardless  of  whether  the  article  which  is 
repaired,  perhaps  by  replacement  of  some  of  its  parts, 
is  one  with  a  life  of  a  few  months  only  or  is  ordinarily 
expected  to  serve  for  some  years.  The  principle  is  al- 
ways the  same.  Such  things  as  machinery  begin  to 
wear  out  or  to  deteriorate  from  the  day  they  go  into 
use.  In  the  case  of  such  things  their  present  value 
can  be  estimated  whenever  a  comparison  is  possible 
between  the  probable  life  of  a  new  article  of  the  same 
kind  whose  cost  is  known  and  the  probable  remaining 
life  of  the  article  whose  present  or  remaining  value  is 
to  be  estimated.  This  fact  makes  it  possible  to  esti- 
mate accrued  depreciation  in  all  cases  in  which  past 
experience  justifies  a  forecast  of  probable  life  new,  and 
probable  remaining  years  of  service.  But  this  depre- 
ciation in  value  in  no  way  affects  the  quality  of  the 
commodity  which  is  furnished  by  the  utility  nor  the 
quality  of  service  rendered,  as  the  case  may  be.  It  is 
of  no  aid  to  the  rate  regulating  authority  to  know  ex- 


DEPRECIATION     AND    APPRECIATION  91 

actly  or  even  approximately  what  the  accrued  depre- 
ciation is,  provided  always  that  the  plant  in  question 
has  not  been  neglected,  that  it  has  been  kept  in  proper 
condition,  that  there  is  no  deferred  maintenance,  and 
that  the  service  rendered  by  it  is  at  full  efficiency  de- 
termined by  the  standard  established  by  the  plant  it- 
self. In  most  cases,  despite  the  lessening  intrinsic 
worth  of  some  or  all  of  the  elements  which  make  up 
a  utility  plant,  its  service  will  improve  with  age.  The 
public  acquires  confidence ;  the  reliability  of  and  de- 
pendability upon  the  service  to  be  rendered  is  on  a 
higher  plane  with  an  old  plant  than  with  a  new  one. 

Needless  though  it  is  to  take  accrued  depreciation 
into  consideration  when  earnings  are  to  be  limited  by 
regulation,  the  requirement  under  the  interpretation 
of  the  law  by  the  highest  court  of  our  country  that 
the  starting  point  must  be  fair  present  value,  compels 
its  consideration,  because,  without  such  consideration 
the  present  value  of  depreciating  elements  can  not  be 
determined. 

Accrued  depreciation  can  only  be  determined  with 
accuracy,  when  the  remaining  life  is  known.  This  is 
the  rare  or  exceptional  case,  as  when  for  some  reason, 
as  in  the  case  of  a  mining  camp,  the  time  can  be  pre- 
dicted when  by  reason  of  exhaustion  of  the  ore-bodies, 
the  camp  must  be  abandoned.  Ordinarily  both  the 
probable  life  new  and  the  remaining  life  for  any  arti- 
cle in  service  which  is  to  be  valued  must  be  estimated. 
It  becomes  a  matter  of  opinion  and  results  can  only  be 
approximate.  Furthermore,  every  prediction  will  be 
based  on  probability  of  failure  at  some  particular  time 
in  the  future,  because  it  is  just  as  likely  that  the  article 
will  serve  beyond  that  time  as  it  is  that  the  article  will 
fail  before  that  time.  The  statement  has  been  made  in 
an  earlier  paper  of  this  series  that  every  calculation 
based  on  such  premises,  even  though  probable  life  has 
been  correctly  estimated,  must  give  results  somewhat 
in  error.  The  current  annual  depreciation  thus  esti- 
mated will  be  somewhat  too  small,  while  the  present 
value  as  determined  from  the  ordinary  formulas  will 
be  somewhat  greater  than  the  actual  value. 


92  PUBLIC    UTILITY    RATE    FIXING 

Mathematical  Demonstration  of  Deficiency  of 
Ordinary  Formulas 

The  mathematical  demonstration  of  these  short- 
comings of  the  generally  accepted  formulas  is  as  fol- 
lows: 

When  the  probable  life  of  an  article  was  n  years 
when  that  article  was  new  and  its  expectancy  or  prob- 
able remaining  life  is  e  years,  at  the  time  for  which 
current  depreciation  is  to  be  determined,  the  current 
annual  depreciation  for  an  original  cost  of  $100  would 
ordinarily  be  estimated  by  the  following  formula : 

Current  annual  depr.  =  100 


where  i  is  the  interest  rate  expressed  decimally,   thus 
.06  for  six  per  cent. 

Or  in  another  simpler  form : 

f    /  f  /-L.  /\  n-e-t 
Current  annual  depr.  =  100 


Call  the  apparent  age: 

n  —  e  =  m 
then  the  formula  may  be  written 

I.  /          -N   m— I    1 
— -± -~ ; (1) 
(/+/)*-/       j 

Now  suppose  that  there  are  two  articles  under 
consideration  whose  expectancy  at  the  time  for  which 
the  current  depreciation  is  to  be  determined  was  e 
years,  but  of  which  one  actually  went  out  of  use  s 
years  before  the  predicted  term  of  its  service  and  the 
other  served  for  s  years  longer  than  had  been  pre- 
dicted. If  these  facts  had  been  known  the  current 
annual  depreciation  of  these  two  articles  would  have 
been  expressed  as  follows  : 

There  would  be 

nij  =  m  +  s  for  the  article  failing  early. 

m,  =  m  —  s  for  the  article  failing  late. 

For  the  article  failing  early 


Cur.  ann.  depr.  =/oo 


DEPRECIATION     AND     APPRECIATION  98 

For  the  article  failing  late 
Cur.  ann.  depr.=  /^? 

For  both  articles, 


Cur.  ann.  depr.  =/00i|  U^LLl +  v  ~rt  ' I    ...(2) 


But  according  to  the  ordinary  method  of  introduc- 
ing expectancy  into  the  calculation  the  current  annual 
depreciation  of  the  two  articles  would  be  estimated 
from  (1)  :  For  both  articles 

f    yf.     -\.rn-,       S 
Cur.  ann.  depr.   .    //>/>/    jfVlELi .    (3) 


/Mi    -7— -Y;-- 
(  (/-t-/;'—/ 

The  current  depreciation  as  correctly  determined 
by  equation  (2)  will  always  be  larger  than  that  found 
by  the  ordinary  method  equation  (3)  because : 


In  the  case  of  the  determination  of  present  value 
if  expectancy  be  made  the  basis  of  the  calculation,  as 
is  the  common  practice,  the  formula  for  the  present 
value  of  an  article  whose  original  cost  was  $100  is  as 
follows : 


Present  value 


(4) 


Let  consideration  be  again  given  to  two  similar 
articles,  the  probable  life  of  each  of  which  when  new 
was  n  years  and  whose  expectancy  at  the  time  when 
valued  was  e  years,  and  whose  history  shows  that 
one  went  out  of  use  s  years  before  its  predicted  date 
of  failure  while  the  second  continued  in  use  for  the 
same  number  of  years  beyond  this  predicted  date. 
These  two  articles  may  stand  for  any  number  of  arti- 
cles whose  actual  terms  of  service  will,  in  part,  fall 
short  of  and  will  in  part  extend  beyond  the  original 
probable  life  term,  which  is  the  problem  for  any  group 
of  articles  all  of  the  same  expectancy. 

We  have  again 

nij  =  m  +  s  for  the  article  that  fails  first,  and 


94  PUBLIC    UTILITY    RATE     FIXING 

m,  =  m  —  s  for  the  article  that  falls  last. 
From  the  above  formula  : 

Pres.  val.  of  the  first  article  .-.-_  M   [/_   (/+/)/>7     ~ 

(         (/+/)*-/ 

f  (/  4.  /)>*-•>_ 

Pres.  val.  of  the  second  article  -  /oo  \  I  --  -  -  '  -  - 

I  (/+/)*—/ 

Pres.  val.  of  the  two  articles 


Determined  on  the  basis  of  expectancy  without 
regard  to  the  fact  that  one-half  of  any  number  of  arti- 
cles must  be  expected  to  and  probably  will  fail  before, 
and  the  other  half  after  the  predicted  date  of  failure, 
the  present  value  of  the  two  articles  would  be  ex- 

pressed by  : 

Pres.  val.  of  both  articles  (ord.  formula) 


(/+/)*-/ 
and  because        n  —  e  =  m 

Pres.  value  of  both  articles  (ord.  formula) 


But       (/+/)"« 

Consequently  the  formula  (5)  containing  the 
larger  negative  term  will  always  give  results  some- 
what smaller  than  formula  (6).  By  the  use  of  ex- 
pectancy and  ordinary  formulas,  therefore,  the  pres- 
ent value  would  be  estimated  somewhat  too  large. 
Fortunately,  the  errors  introduced  by  using  the  ordi- 
nary formulas  based  on  sinking  fund  methods  of  cal- 
culation are  not  a  matter  of  great  importance  because 
the  basic  elements  to  be  taken  into  account,  the  prob- 
able life  new  and  the  expectancy  after  a  period  of  serv- 
ice, are  approximations  based  on  expert  judgment  and 
may  be  at  considerable  variance  with  actual  facts. 


DEPRECIATION     AND     APPRECIATION  95 

Determination  of  the  Current  Replacement 
Requirement  Essential 

Here  is  an  additional  reason  why  value  should  not 
appear  in  the  rate-base.  But  even  though  the  necessity 
of  computing  accrued  depreciation  and  present  value, 
falls  away  when  rates  are  to  be  fixed,  the  other  prob- 
lem of  estimating  the  replacement  requirement  is  ever 
present.  The  replacement  requirement  is  often,  though 
loosely,  referred  to  as  offsetting  current  depreciation. 
The  allowance  in  the  earnings  is  then  referred  to  as  an 
allowance  for  depreciation.  This  allowance  thereby 
assumes  the  aspect  of  an  amortization  of  capital  to  the 
extent  that  there  has  been  lessening  of  worth  and 
lends  plausibility  to  the  use  of  the  remaining  or  pres- 
ent value  of  physical  elements  in  the  rate-base.  That 
this  is  not  necessary  for  correctly  estimating  proper 
earnings  has  been  fully  demonstrated  by  the  author 
in  "Valuation,  Depreciation  and  the  Rate-Base,"  and 
in  various  papers  contributed  to  the  Transactions  of 
the  American  Society  of  Civil  Engineers  and  the  dem- 
onstration need  not  be  repeated  here.  It  is  only  neces- 
sary to  say  that  any  money  accumulating  in  a  fund  for 
replacements  should  be  regarded  as  being  at  the  dis- 
posal of  the  utility  owner  for  any  purpose  and  that, 
theoretically,  in  so  far  as  the  ultimate  result  is  con- 
cerned, it  would  make  no  difference  whether  the  own- 
er is  allowed  an  interest  return  on  present  value  plus 
so-called  current  depreciation  estimated  from  remain- 
ing value  and  remaining  life  or  whether  he  is  allowed 
interest  on  full  value  new  (original  investment)  plus 
the  replacement  or  depreciation  increment  which  will 
in  the  life  term  provide  the  funds  necessary  for  re- 
placement, provided  always  that  the  life  term  of  any 
article  in  question  could  be  known  in  advance. 

Consideration  of  this  fundamental  truth,  coupled 
with  the  fact  that  accrued  depreciation  is  not  sus- 
ceptible of  precise  determination,  has  led  the  author 
to  recommend  for  general  application  the  procedure 
which  he  has  named  the  "Unlimited  Life  Method  of 
Procedure,"  under  which  a  clear  distinction  is  made 
between  value  and  rate-base  and  under  which  provi- 


96  PUBLIC    UTILITY    RATE    FIXING 

sion  for  replacements  is  to  be  made  as  required,  being 
treated  as  though  replacements  were  repairs  on  a  large 
scale,  to  be  foreseen  before  the  necessity  arises  to 
make  them,  and  under  which  therefore  the  earnings 
should  be  ample  to  provide  a  fund  out  of  which  either 
to  meet  the  replacement  requirements  or  to  reimburse 
the  owner  after  they  have  been  made. 

Appreciation  in  Relation  to  Rates 

The  value  of  an  income  producing  property  is 
ordinarily  determined  from  its  earnings.  As  its  net 
earnings  increase  its  value  increases.  There  may  be  a 
material  increase  of  value,  therefore,  without  any  in- 
crease of  investment.  The  earning  power  of  public 
utilities,  as  a  general  rule,  if  rates  remain  stable,  in- 
creases as  population  increases,  although  not  neces- 
sarily in  the  same  ratio.  The  appreciation  or  increase 
of  value  which  results  when  net  earnings,  in  their  re- 
lation to  the  investment,  are  increasing  follows  no 
definite  law  and  it  cannot  be  forecast  with  that  degree 
of  certainty  which  can,  with  some  reason,  be  claimed 
for  depreciation.  Just  as  depreciation  represents  a 
loss  so  does  appreciation  or  increase  of  value  without 
increase  of  investment  represent  a  gain.  It  is  an  un- 
earned increment  which  results  from  the  changing  con- 
ditions of  environment. 

Usefulness  in  service,  and  therefore  value,  does 
not  always  decrease,  but  may  sometimes  increase  with 
age.  This  may  be  the  case  with  a  dam,  or  with  a  rail- 
way embankment  which  become  more  dependable  with 
advancing  age.  Increasing  value  may  also  result  from 
an  advance  in  the  price  of  labor  and  materials,  or  from 
changes  in  the  conditions  u.nder  which  an  enterprise 
was  first  established  which  would  render  more  expen- 
sive the  construction  or  establishment  of  the  enterprise 
under  the  altered  conditions. 

Stated  broadly,  values  as  expressed  in  terms  of 
money  are  increasing.  This  applies  not  alone  to  the 
value  of  real  estate  and  water  rights  and  like  proper- 
ties, but  also,  the  same  condition  of  serviceability  be- 
ing assumed,  to  physical  elements  generally,  and  to 


DEPRECIATION     AND     APPRECIATION  97 

intangibles.  It  is  also  true  that,  as  a  general  rule, 
public  utilities  are  to  be  included  among  the  prin- 
cipal factors  which  are  responsible  for  the  growth  of 
communities,  and  that  when  viewed  in  this  light,  the 
owners  thereof  are  entitled  to  participate  in  the  un- 
earned increment  or  in  the  general  prosperity  just  as 
the  land  owner  participates.  They  do  so,  of  course,  as 
their  business  increases,  but  if  held  down  to  earnings 
which  will  only  yield  the  ordinary  interest  rate  on  safe 
investment  or  only  the  interest  at  which,  for  use  in 
similar  enterprises,  money  can  be  borrowed,  the  ex- 
tent of  sharing  in  the  general  prosperity  may  fall  far 
short  of  the  rate  at  which  values  generally,  and  par- 
ticularly land  values,  are  advancing. 

Appreciation  Referred  to  in  Court  and  Public  Service 
Commission  Decisions 

Such  considerations,  although  not  thus  expressed, 
have  led  the  United  States  Supreme  Court  to  hold 
that  the  owner  of  a  public  utility  is  entitled,  in  most 
cases  at  any  rate,  to  have  the  present  value  of  his  prop- 
erty made  the  basis  of  the  computation  wThen  rates  are 
to  be  fixed.  In  the  Consolidated  Gas  Co.  case  (Wm. 
R.  Willcox  et  al.  vs.  Consolidated  Gas  Co.  of  N.  Y., 
212  U.  S.  19),  the  court  says: 

"And  we  concur  with  the  court  below  in  holding  that  the 
value  of  the  property  is  to  be  determined  as  of  the  time  when 
the  inquiry  is  made  regarding  the  rates.  If  the  property 
which  legally  enters  into  the  consideration  of  the  question 
of  rates  has  increased  in  value  since  it  was  acquired,  the  com- 
pany is  entitled  to  the  benefit  of  such  increase.  This  is  at 
any  rate  the  general  rule.  We  do  not  say  that  there  may 
not  possibly  be  an  exception  to  it  where  the  property  may 
have  increased  so  enormously  in  value  as  to  render  a  rate 
permitting  a  reasonable  return  upon  such  value  unjust  to  the 
public." 

If  this  view  be  accepted,  as  it  is  by  those  who 
consider  rate-base  and  present  value  synonymous,  the 
question  is  where  to  stop.  Must  this  matter  of  adding 
appreciation  and  allowing  a  return  thereon  as  though 
it  were  additional  investment  go  on  forever."  If  this 
is  the  theory  its  application  will  hasten  universal  pub- 


98  PUBLIC     UTILITY     RATE     FIXING 

lie  ownership  of  public  utilities.  Should  not  a  limit 
be  set  and  thereafter  the  rate-base  remain  unaffected 
by  appreciation?  The  allowance  for  appreciation,  or 
better,  an  allowance  for  participation  in  general  pros- 
perity, should  then  appear  in  the  earnings.  The  owner 
should  be  allowed  a  fair  amount  of  current  apprecia- 
tion with  which  he  may  do  what  he  pleases,  and  the 
public  will  hold  down  the  rate-base  to  what  is  esti- 
mated to  be  the  properly  invested  capital  at  the  time 
the  rate-base  was  established.  The  court  has  appra- 
rently  overlooked  the  fact  that  an  unearned  incre- 
ment can  be  thus  allowed  in  the  earnings,  and  that  if 
thus  allowed  the  public  utility  which  has  no  appreci- 
ating real  estate  will  fare  as  well  as  those  public  util- 
ities which  own  large  areas  of  land  or  other  appreciat- 
ing properties. 

Rental  Compared  with  Ownership 

In  weighing  the  question  whether  or  not  appre- 
ciation is  to  be  added  to  the  rate-base,  consideration 
may  be  given  to  the  alternative  of  the  rental  value  of 
equivalent  property.  Suppose  for  example  that  among 
the  properties  owned  by  a  public  utility  there  is  a 
large  tract  of  land  located  in  a  region  in  which  real 
estate  values  are  advancing  normally.  If  instead  of 
acquiring  this  land  the  owner  of  the  utility  had  en- 
tered into  a  lease  thereof  based  upon  an  agreement 
that  the  rent  from  year  to  year  should  be  commensu- 
rate with  a  proper  valuation  of  the  land,  the  amount 
of  the  rent  increasing  from  year  to  year  would  be  in- 
cluded in  the  cost  of  operation  and  rates  would  be  fixed 
as  though,  in  the  case  of  actual  ownership,  the  rate- 
base  had  included  appreciation. 

\Yhile  by  such  reasoning  a  sound  foundation  may 
be  laid  for  the  inclusion  of  appreciation  in  the  ap- 
praisal of  the  rate-base,  there  will  always  be  some 
cases  in  which  appreciation  has  been  so  great  that  it 
would  be  unfair  to  the  rate-payer  to  let  the  full  bene- 
fit thereof  go  to  the  owner  of  the  utility.  Why  should 
not  the  public,  and  particularly  the  rate-payer,  be  al- 
lowed to  participate  in  a  measure  in  the  unearned  in- 


DEPRECIATION     AND     APPRECIATION  99 

crement  which  is  the  result  of  general  prosperity  and 
development  of  resources  and,  therefore,  in  part  at- 
tributable to  the  presence  of  the  rate-payer?  Not  only 
may  such  questions  be  asked,  but  it  will  be  proper  to 
consider  that  while  it  may  be  a  simple  matter  to  deter- 
mine from  time  to  time  the  appreciating  value  of  land, 
this  may  be  difficult  and  uncertain  in  the  case  of  other 
kinds  of  property. 

The  Interstate  Commerce  Commission  Has  Difficulty 
in  Dealing  with  Appreciation 

The  difficulty  of  conforming  to  the  decision  of  the 
United  States  Supreme  Court  in  the  matter  of  allowing 
the  appreciation  of  real  estate  was  felt  by  the  Inter- 
state Commerce  Commission  of  the  United  States, 
which  says  in  its  opinion  in  the  Western  Advanced 
Rate  Case  (20  I.  C.  C.  Rep.  344,  decided  February  22, 
1911): 

"Certainly  if  the  Supreme  Court  may  decline  to  lay  down 
the  absolute  rule  that  'in  every  case  failure  to  produce  some 
profit  to  those  who  have  invested  their  money  in  the  building 
of  a  road  is  conclusive  that  the  tariff  is  unjust  and  unreason- 
able' (Reagan  vs.  Farmer  Loan  and  Trust  Co.,  154  U.  S.  412), 
it  is  a  conservative  statement  of  the  law  to  hold  that  a  rail- 
road may  not  increase  the  rates  upon  a  number  of  commodi- 
ties solely  because  its  real  estate  has  risen  in  value." 

"While  it  is  evident,  therefore,  that  each  case  must  be 
decided  upon  the  facts  peculiar  to  it,  the  Commission  believes 
it  proper  in  this  case  to  follow  the  general  rule,  as  stated 
by  Judge  Hough  of  the  United  States  Circuit  Court  (Consol- 
idated Gas  Co.  vs.  City  of  New  York  et  al.,  157  Fed.  Rep. 
849,  855),  'Upon  reason,  it  seems  clear  that  in  solving  this 
question  the  plus  and  minus  quantities  should  be  equally  con- 
sidered, and  appreciation  and  depreciation  treated  alike.' 
*  *  *  Thus  land  has  been  taken  at  its  fair  value  and  not 
at  its  original  cost,  and  the  annual  appreciation  of  land  has 
been  treated  as  a  profit.  By  this  method  all  property  is 
treated  absolutely  alike,  as  Judge  Hough  suggests.  No  dif- 
ference is  made,  except  that  as  depreciation  represents  a  de- 
crease in  assets,  it  is  placed  as  a  debit  against  operation, 
while  appreciation  is  placed  as  a  credit  because  it  is  an  in- 
crease in  assets." 


100  PUBLIC     UTILITY     RATE     FIXING 

Treatment  of  Depreciation  and  Appreciation 
Compared 

The  difference  between  the  ordinary  treatment  of 
depreciation  and  of  appreciation  results  from  the  fact 
that  in  the  case  of  depreciation,  which  is  continuous 
and  can  be  estimated,  a  definite  annual  allowance  can 
be  made  in  the  earnings  to  offset  it,  while  in  the  case 
of  appreciation,  which  cannot  be  estimated  from  year 
to  year,  it  is  not  ordinarily  treated  as  revenue.  When 
the  occasional  appraisal  discloses  appreciation  it  is 
treated  as  profit.  The  Interstate  Commerce  Commis- 
sion believes  that  depreciation  and  appreciation  should 
be  treated  alike.  The  United  States  Supreme  Court 
holds  that  the  owner  of  the  public  utility  is  entitled 
to  the  appreciation  unless  the  same  is  excessive  in 
amount.  It  would  be  much  simpler,  as  already  stated, 
to  grant  to  the  utility,  after  a  rate-base  has  been  prop- 
erly determined,  some  reasonable  share  in  the  general 
prosperity  not  measured  solely  by  the  value  increase 
of  real  estate  and  other  property,  and  preferably 
brought  into  some  relation  to  the  volume  of  business 
instead  of  to  the  rate-base.  Under  the  ruling  of  the 
courts,  however,  in  determining  present  va!ue  there  is 
no  escape  from  a  consideration  of  reproduction  cost 
and  the  reproduction  cost  will  include  appreciation. 
Under  this  ruling  all  relation  between  actual  original 
cost  and  permissible  earnings  may  be  lost.  \\  hen  the 
courts  shall  have  accepted  the  view  that  "fair  value" 
is  not  the  proper  starting  point,  then  the  importance 
of  making  a  close  estimate  of  cost  of  reproduction, 
which  includes  both  depreciation  and  appreciation, 
will  fall  away. 


THE     VALUE     OF     A     WATER     RIGHT  101 


CHAPTER  VI 

THE  VALUE  OF  A  WATER  RIGHT 

Recognition  of  Value 

When  water  is  used  for  irrigation  it  makes  the  in- 
tense cultivation  of  the  soil  possible.  It  aids,  as  stated 
in  a  preceding  chapter,  in  producing  crops  which  can 
be  marketed  at  prices  not  subject  to  regulation  except 
by  the  law  of  supply  and  demand.  The  availability 
and  use  of  the  irrigation  water  modify  the  character 
and  increase  the  amount  and  consequently  the  value 
of  the  crop.  These  elements  may  thus  add  an  incre- 
ment of  value  to  the  irrigated  land.  Under  such  use, 
the  value  of  the  water  at  the  field  and,  upon  allowance 
for  the  cost  of  development,  its  value  at  its  source  can 
be  determined.  Water  and  water  rights  in  districts 
where  water  is  used  for  irrigation  acquire,  in  conse- 
quence, a  recognized  market  value,  depending  upon 
the  resulting  appreciation  of  the  land,  upon  the  value 
of  the  crops  harvested  in  relation  to  the  cost  of  pro- 
duction, and  upon  the  cost  of  developing  and  making 
the  irrigation  water  available. 

When  water  is  taken  from  a  stream  for  uses  which 
decrease  or  otherwise  modify  the  natural  flow  of  the 
stream  or  when  works  are  constructed  which  raise  or 
lower  the  water  plane  of  the  stream  the  rights  of  ripa- 
rian owners  may  thereby  be  aiiccted.  Contemplated 
diversion  can  not  be  made  nor  can  proposed  works  be 
constructed  in  such  cases,  without  making  compensa- 
tion to  the  riparian  owners  for  the  resulting  damage  to 
their  property,  except  of  course  when  such  owners 
sleep  upon  their  rights. 

To  the  extent  of  the  cost  of  extinguishing  the  ripa- 
rian rights  and  possibly  of  securing  other  water  rights 
whose  use  is  secondary  or  which  for  anv  reason  should 
be  merged  in  one  holding,  there  is  then--  a  public  util- 
ity being  under  consideration — an  investment  to  be  as- 
sumed in  that  intangible  element — the  water  riirht. 


102  PUBLIC     UTILITY     RATE     FIXING 

Sometimes  by  reason  of  local  development  and 
high  values  of  riparian  lands  and  the  use  of  the  stream 
flow  for  power,  the  cost  of  settling  with  the  riparian 
owners  and  of  eliminating  adverse  users  of  the  water 
may  be  large.  At  other  times  the  situation  is  such 
that  equally  good  rights  to  use  water  can  be  secured 
without  any  cost  except  the  cost  incident  to  the  con- 
struction of  the  project  features  and  the  acquisition  of 
the  necessary  lands  and  rights  of  way. 

The  fact  that  in  the  first  case  it  will  have  to  be 
conceded  that  the  owner  of  the  public  utility  is  entitled 
to  have  the  cost  of  the  water  right  which  he  holds 
made  a  part  of  the  rate-base  and  that  at  least  to  the 
extent  of  cost  (reasonable  and  actual  proper  cost  being 
assumed)  this  water  right  has  or  should  be  made  to 
have  value,  justifies  the  public  in  concluding  that  the 
other  water  right  which  has  cost  nothing  should  have 
a  similar  value  whether  the  same  be  made  a  part  of 
the  rate-base  or  not.  Water  rights  applying  to  water 
whose  use  is  demanded  by  society,  are  then  to  be  re- 
garded as  having  market  value.  When  the  water  is 
developed  and  is  in  use  or  is  available  for  use  or  when 
the  need  of  putting  the  water  to  beneficial  use  is  prox- 
imate, the  existence  of  such  value  is  easily  recognized. 
When  an  investment  has  been  necessary  to  eliminate 
adverse  rights  and  to  meet  other  expense  of  securing 
the  water  right,  the  propriety  of  including  its  cost  in 
the  rate-base  is  unquestioned. 

According  to  the  decision  of  the  U.  S.  Supreme 
Court  in  the  case  of  San  Joaquin  and  Kings  River 
Canal  and  Irrigation  Company  v.  the  County  of  Stan- 
islaus, California,  the  water  right  must  receive  the 
same  consideration  as  other  property  when  rates  are 
to  be  fixed.  But  the  court  does  not  attempt  to  settle 
the  question  of  how  a  water  right  is  to  be  valued. 

The  right  to  appropriate  flowing  water  and  to  put 
the  same  to  beneficial  use  is  given  by  law,  in  most  of 
the  Western  states,  to  any  one  who  will  construct 
proper  works  for  the  development  of  the  water  and  for 
its  transmission  to  places  of  use.  The  water  of  the 
stream  is  reserved  to  the  public.  The  grant  of  the 


THE     VALUE     OF     A     WATER     RIGHT  103 

right  to  take  water  from  a  stream  and  put  it  to  some 
beneficial  use  is  comparable  with  a  franchise.  This 
right  may  have  value  for  the  same  reason  that  a  fran- 
chise or  intangible  element  of  property  may  have 
value,  that  is  because  the  exercise  of  this  right  may 
result  in  net  earnings  creating  value  in  excess  of  the 
investment  in  physical  property.  Whether  the  market 
value  of  the  water  right,  or  the  investment  that  was 
made  to  secure  it,  is  to  be  made  a  part  of  the  rate-base 
will  depend  upon  whether  value  or  the  investment  is 
to  be  made  the  starting  point  when  rates  are  to  be 
fixed. 

The  courts  and  the  rate  fixing  authorities,  accept- 
ing the  view  of  the  public,  but  still  generally  adhering 
to  the  fiction  that  fair  value  is  the  basis  of  the  calcula- 
tion, not  only  hold  that  water  rights  may  have  value 
but  that  they  should  appear  at  their  market  value  in 
the  rate  base.  But  neither  the  courts,  nor  public  serv- 
ice commissions,  nor  valuation  experts,  have  yet  dis- 
covered any  dependable  method  of  determining  this 
market  value. 

Regional  Cost  of  Development  Considered 

The  method  of  estimating  the  market  value  of  a 
water  right  in  the  case  of  water  used  to  supply  the 
needs  of  an  urban  population,  by  comparison  with  the 
ordinary  or  average  cost  of  developing  water  in  the 
same  region  in  like  amount,  of  like  quality  and  under 
similar  conditions  of  deliver)',  has  occasionally  been 
applied,  but  not  with  satisfactory  results. 

To  illustrate,  let  it  be  assumed  that  the  average 
ordinary  cost  of  supplying  water  for  domestic  use  in 
the  region  in  which  water  right  is  to  be  valued  is  10 
cents  per  1000  gallons.  This  amount  is  here  supposed 
to  include  interest  on  the  investment  and  cost  of  opera- 
tion. Let  it  be  further  assumed  that  the  cost  of  sup- 
plying by  the  system  whose  water  rights  is  to  be  val- 
ued has  been  found  to  be  9  cents  per  1000  gallons.  A 
comparison  of  these  costs  of  supplying  water  indicates 
that  the  value  of  the  water  right  under  appraisal  is  as- 
certainable  by  the  capitalization  of  1  cent  per  1000  gal- 


104  PUBLIC     UTILITY     RATE     FIXING 

Ions.  It  will  readily  be  seen  that  under  such  circum- 
stances a  rise  of  10  per  cent  or  1  cent  per  1000  gallons 
in  the  average  regional  cost  of  water  production  would 
have  the  absurd  effect  of  doubling  the  value  of  the 
water  right. 

Furthermore,  in  the  case  of  every  ascertainment  of 
average  regional  cost  those  properties  which  are  least 
favorably  circumstanced  must  fall  above  the  average 
to  offset  those  which  fall  below.  The  former  may 
nevertheless  be  entitled  to  the  same  standard  of  treat- 
ment as  is  accorded  the  latter.  And  yet,  under  this 
test  of  value,  all  of  those  whose  cost  of  developing 
their  supplies  exceeds  the  average,  would  have  to  con- 
sider their  water  rights  liabilities  and  not  assets.  This 
is  an  absurdity  and  condemns  the  method. 

Neither  this  method  nor  a  comparison  with  the 
cost  of  developing  the  next  most  available  supply  can 
be  used  as  a  dependable  method  for  determining'  wa- 
ter right  value. 

In  some  sections  of  the  country,  as  for  example  in 
certain  portions  of  California,  the  demand  for  irriga- 
tion water  has  nearly  if  not  quite  reached  the  limit  of 
supply.  In  such  regions  the  depressing  effect  upon  the 
value  of  water  rights  which  results  from  large  unde- 
veloped available  sources  is  no  longer  felt.  The  earn- 
ings that  result  from  the  use  of  the  water  are  large  and 
have  become  the  measure  of  value  and  this  value  is 
consequently  relatively  high. 

The  value  of  water  rights  in  such  sections  has  an 
effect  upon  the  value  of  water  rights  elsewhere  and  for 
uses  other  than  irrigation.  The  value  of  water  used 
for  domestic  purposes,  domestic  use  being  imperative, 
should  not  be  less  than  that  of  water  used  in  the  same 
locality  for  irrigation  and  if  for  this  purpose  it  has  a 
high  value  in  one  part  of  the  state — the  question  is 
asked — why  not  in  another?  Such  considerations  as 
these  are  not  without  effect  upon  the  maket  value  of 
water  rights. 

To  the  extent  that  the  value  of  a  water  right  as 
taken  into  the  rate-base  other  than  the  natural  rate- 


THE     VALUE     OF    A     WATER     RIGHT  105 

base  of  a  public  service  property  exceeds  the  cost  of 
the  water  right,  the  owner  is  conceded  a  profit  or  re- 
ward for  undertaking  the  development,  and  this  profit 
or  compensation  increment  might  reasonably  be  ex- 
pected to  bear  some  definite  relation  to  the  general 
cost  of  developing  water  in  any  region. 

The  practice  of  thus  making  a  reasonable  allow- 
ance for  water  right  value,  preferably  a  percentage  al- 
lowance for  the  ordinary  regional  cost  of  developing 
water  resources,  has  not  yet  been  anywhere  estab- 
lished, but  in  the  writer's  judgment  would  have  merit. 
If  this  practice  were  generally  adopted,  it  would  result 
in  fixing  with  some  definiteness  the  value  of  water  at 
its  source  and  would  remove  much  of  the  uncertainty 
that  now  obtains  in  relation  to  the  value  of  water 
rights.  Moreover,  if  thus  determined,  the  value  of 
the  water  right  would  not  be  subject  to  unreasonable 
fluctuation  nor  to  too  wide  a  range.  Where  the  re- 
gional cost  of  development,  including  everything 
necessary  to  make  the  water  available  for  distribution 
is  10  cents  per  1000  gallons  and  the  allowance  for  wa- 
ter rights  is  to  be  about  10  per  cent  of  this  amount,  or 
1  cent  per  1000  gallons,  a  departure  of  1  per  cent  in 
the  cost  of  water  development  from  this  regional  av- 
erage would  only  modify  the  value  of  the  water  at  the 
source  by  0.1  per  cent.  A  10  per  cent  departure  would 
be  necessary  to  affect  this  value  by  1  per  cent.  In 
other  words,  when  once  an  amount  has  been  agreed 
upon  and  generally  accepted  as  a  proper  allowance  to 
be  made  for  the  value  of  a  water  right  or  rather, 
when  such  value  is  to  be  created  by  a  suitable  allow- 
ance of  earnings,  this  value  will  be  fairly  stable  and 
being  then  readily  ascertainable,  will  thereafter  when 
definitely  recognized  by  the  public,  pass  as  the  market 
value. 

Strategic  Value 

But  in  addition  to  the  basic  value  at  its  source,  a 
water  supply  may  have  additiional  value  due  to  an  es- 
tablished market  and  an  inherent  advantage  of  quality 
and  location  and  to  other  circumstances  that  determine 


106  PUBLIC     UTILITY    RATE     FIXING 

its  development  cost  in  comparison  with  the  develop- 
ment cost  of  competing  supplies.  Such  value  may  be 
termed  "strategic  value." 

To  illustrate,  a  riparian  ownership  which  controls 
a  water  power  may  be  cited.  The  case  may  readily  be 
conceived  of  such  a  water  power,  limited  in  amount, 
which  is  completely  controlled  by  a  riparian  owner. 
When  such  a  source  of  power  is  to  be  valued  in  a  re- 
gion where  the  market  for  power  is  good,  where,  for 
example,  the  water  power  will  be  delivered  to  a  market 
in  which  it  displaces  a  like  amount  of  power  generated 
by  steam,  the  cost  of  the  latter  in  comparison  with 
the  cost  of  the  former,  affords  a  legitimate  means  of 
determining  value  or,  better  stated,  ordinarily  an  up- 
per limit  of  value.  The  valuation  becomes  a  simple 
matter  when,  under  such  circumstances  the  power  is 
already  fully  developed  and  is  in  use  or  is  being  sup- 
plied to  a  market  which  takes  it  all.  But  when,  the 
market  for  power  is  undeveloped,  some  consideration 
must  be  given  to  the  uncertainty  of  achieving  the  ex- 
pected results  and  due  allowance  must  be  made  for 
the  time  that  will  have  to  elapse  before  a  return  from 
the  sale  of  power  can  be  realized. 

There  will,  of  course,  be  cases  in  which  an  analysis 
of  the  cost  of  generating  and  delivering  power  will 
show  the  advantage  to  be  with  the  power  developed  by 
steam.  This  may  obtain  when  from  any  cause,  such 
as  an  irregular  water  supply,  the  load  factor  on  the 
hydro-electric  plant  is  unfavorable  or  when  the  cost  of 
water  development  and  transmission  of  power  to  the 
place  of  use  is  materially  higher  than  it  \vould  be  from 
a  properly  located  steam  plant.  In  such  cases  the 
hydro-electric  enterprise  may  nevertheless  be  a  legiti- 
mate one.  It  may  have  been  initiated  when  the  price 
of  fuel  for  generating  steam  was  such  that  the  ad- 
vantage of  cost  was  temporarily  with  the  water  power ; 
or  the  margin  in  favor  of  the  steam  power  may  be  so 
small  that  the  recognized  advantage  and  economic 
value  to  society  in  conserving  the  energy  which  annu- 
ally reappears  in  the  water  of  the  stream  outweighs 
any  financial  disadvantage  that  may  appear  from  a 


THE     VALUE     OF     A     WATER     RIGHT  107 

comparison  with  steam  as  a  source  of  power,  and  justi- 
fies earnings  that  might  not  under  other  circumstances 
be  considered  reasonable. 

Water  Power  Development  Should  Be  Encouraged 

In  concluding  the  foregoing  article  a  reference 
was  made  to  the  economic  value  to  society  which 
results  from  the  development  of  the  energy  in  flowing 
water.  Any  one  who  engages  in  the  business  of  con- 
trolling and  marketing  this  energy  deserves  not  only 
adequate  protection  of  his  investment,  but  also  some 
reward  for  doing  that  which  conserves  other  valuable 
natural  resources. 

Under  this  view,  even  when  the  water  right  which 
makes  the  development  of  power  possible  would  ap- 
pear to  be  without  market  value  at  current  fuel  prices, 
it  will  be  reasonable  to  allow  to  the  owner  not  alone 
a  rate-base  increment  equal  to  the  cost  of  securing  the 
water  right,  if  there  has  been  any  such  cost,  but  also, 
if  this  cost  has  been  legitimate  and  reasonable,  a  fair 
excess  allowance  in  the  earnings,  perhaps  proportional 
to  the  amount  of  power  developed  rather  than  to  the 
actual  investment  in  works  for  developing  and  market- 
ing this  power.  But  this  can  only  be  done  \vithin 
limits  or  so  long  as  the  rates  for  the  service  remain 
reasonable.  When  it  would  require  excessive  rates, 
the  owner  must  sffer  the  penalty  of  having  made  an 
untimely  if  not  an  unwise  investment. 

It  seems  hardly  necessary  to  add  that  the  national 
and  state  policy  should  be  to  grant  liberal  terms,  and 
even  to  assure  a  bonus  in  special  cases,  to  those  who 
in  proper  manner  and  on  a  scale  commensurate  with 
physical  conditions  and  with  industrial  and  other 
requirements  will  enter  upon  the  development  and 
marketing  of  the  energy  in  the  flowing  stream.  The 
wise  policy  would  be  to  grant  terms  which  will  assure 
a  fair  profit,  but  under  which,  after  a  reasonable  time, 
preferably  about  50  years,  which  is  a  short  period  in 
national  and  state  life,  the  control  of  the  water 
power  and  the  power  plant  itself  with  all  acces- 
sories, at  a  fair  price  for  physical  elements,  will 


108  PUBLIC     UTILITY     RATE     FIXING 

revert  to  the  government,  so  that  then,  if  it  appears 
desirable,  new  terms  of  use  can  be  agreed  upon.  By 
such  a  liberal  policy  the  early  development  of  water 
powers  will  be  assured  and  the  utilization  of  energy 
which  nature  annually  replenishes  will  help  to  con- 
serve that  which  must  otherwise  be  obtained  by  the 
inefficient  consumption  of  a  limited  store  of  oil  and 
coal. 

The  Life  of  the  Right  Affects  Its  Value 

The  water  right  as  thus  far  discussed  applies 
particularly  to  the  right  to  put  water  to  a  continuing 
beneficial  use  without  limit  as  to  the  time  during 
which  such  right  may  be  exercised.  There  will  be 
cases  of  reversion  of  the  right  within  a  fixed  time  to 
the  people  who  have  made  the  grant  thereof  and  there 
will  be  other  cases  in  which  a  superior  supply  of  water, 
later  to  be  developed,  may  at  some  time  throw  the 
original  source  out  of  use  altogether  or  leave  it  avail- 
able for  only  inferior  uses.  Where  a  water  right  thus 
or  otherwise  limited  in  its  life  is  to  be  valued,  the 
question  not  only  arises  as  to  whether  it  has  strategic 
value,  but  also  what  effect  time  will  have  upon  the 
value. 

Earnings  Create  Value 

The  value  of  any  water  right  in  excess  of  its  cost, 
like  the  value  of  a  franchise,  results  as  already  stated, 
from  earnings  in  excess  of  ordinary  interest  on  the 
investment.  This  value  is,  therefore,  directly  depend- 
ent upon  the  rates  established  by  the  rate  fixing 
bodies,  or  in  the  case  of  operation  under  a  franchise, 
upon  the  rates  limited  by  the  terms  thereof  and  lim- 
ited by  the  further  requirement  that  they  must  not 
exceed  'what  the  traffic  will  bear.'  Large  power  is  in 
the  hands  of  the  rate  fixing  authorities  to  make  or  to 
destroy  the  value  of  water  at  its  source  and  until  a 
definite  policy  has  been  adopted  by  such  authorities, 
there  will  continue  to  be  more  or  less  uncertainty 
relating  to  such  value.  The  real  value  of  property  of 
this  character  will,  for  the  present,  remain  somewhat 
speculative,  particularly  in  cases  where  the  develop- 
ment of  the  water  or  of  a  water  power  lies  in  an  uncer- 


THE     VALUE     OF     A     WATER     RIGHT  109 

tain  future.  This  can  hardly  be  otherwise  because  it 
is  not  yet  certain  that  the  tendency  of  today  to  allow 
something  when  value  is  made  the  rate-base  for  the 
water  right  in  addition  to  cost  will  be  adhered  to. 
When  it  is  generally  understood  that  such  an  allow- 
ance, practically  as  compensation  for  making  the 
development,  will  be  made  and  when  the  amount 
thereof  to  be  expected  under  ordinary  circumstances 
can  be  approximated,  the  valuation  experts  will  be 
relieved  of  much  embarrassment. 

In  the  case  of  the  established  utility,  much  of  the 
difficulty  ordinarily  encountered  when  water  rights 
or  franchises  are  to  be  valued  will  fall  away  if  the 
method  of  procedure  in  fixing  rates  which  the  writer 
recommends  be  followed  and  the  invested  capital  and 
not  present  value  be  made  the  rate-base. 

The  San  Francisco  Rate  Case 

Since  the  above  notes  on  the  value  of  water  rights 
were  written  the  report  of  the  Standing  Master  in 
Chancery,  Mr.  II.  M.  Wright,  in  the  case  of  the 
Spring  Valley  Water  Company  vs.  City  and  County 
of  San  Francisco  (rate  case)  has  been  filed  with  the 
court  (Oct.  17,  1917)  and  merits  notice.  The  Master 
says  on  the  subject  of  valuing  water  rights: 

"The  valuation  of  the  plaintiff's  water  rights  is  con- 
sidered by  counsel  for  both  parties  the  most  difficult  single 
subject  in  this  litigation.  *  *  *  There  is  little  or  nothing 
in  the  way  of  decided  cases  to  afford  a  guide  to  the  prin- 
ciples of  such  a  valuation." 

In  speaking  of  the  value  assigned  to  a  right  of 
property,  additional  to  that  of  the  land  and  structures 
which  its  exercise  requires  where  it  cost  nothing  as 
a  historical  fact,  the  Master  says: 

"Such  is,  in  essence,  and  often  in  fact,  the  right  to 
appropriate  water.  I  have  been  especially  struck  with  this 
peculiarity  of  this  right  of  property  because  I  have  never 
seen  anything  like  it  among  the  various  rights  of  property 
or  elements  of  value  that  usually  enter  into  the  properties 
of  a  public  utility  subject  to  appraisal.  Usually  the  elements 
of  value  have  bef>n  the  result  of  expenditure,  and  would  cost 
money  to  reproduce;  or,  if  they  cost  nothing  as  by  gift  or 
adverse  user,  would  be  the  subject  of  estimated  cost  in  the 


110  PUBLIC     UTILITY     RATE     FIXING 

reproductive  method.  Here  in  any  view,  the  right  arises  by 
the  act  of  diversion.  Like  the  miner's  right,  it  is  a  valuable 
right  conferred  by  the  United  States,  and  in  the  case  of 
water  by  the  State  also,  to  him  who  finds  and  takes.  And 
just  as  the  miner  has  in  his  mining  claim,  after  discovery 
and  location,  a  property  which  may  possess  value  in  exchange 
far  beyond  his  expenditure  of  labor  and  money  thereon,  so 
the  appropriator  has  in  his  right  of  diversion,  a  right  sep- 
arate from  his  rights  in  lands  and  structures,  and  which 
may  in  a  given  case  have  a  sale  value  far  beyond  his  ex- 
pended costs.  And  in  the  normal  case,  the  value  upon  which 
rates  can  be  earned  is  the  exchange  value  in  the  market." 

The  doctrine  of  riparian  rights  was  established  in 
California  as  a  rule  of  law  when  the  State  Legislature 
in  1850  declared  that : 

"The  common  law  of  England,  so  far  as  it  is  not  repug- 
nant to  or  inconsistent  with  the  Constitution  of  the  United 
States,  or  the  Constitution  or  laws  of  the  State  of  California 
shall  be  the  rule  of  decision  in  all  the  Courts  of  this  State." 
Referring  to  this  fact  the  Master  says : 

"It  may  be  doubted  whether  by  intention  of  the  legis- 
lators of  that  early  day,  or  by  the  language  employed,  the 
riparian  law  was  established  along  with  the  antithetic  exist- 
ing water  system  of  appropriation.  We  need  not  follow  the 
history  of  this  question  as  to  the  existence  of  the  riparian 
rule  in  this  state  through  the  years;  it  was  established  as 
the  law  in  the  common  law  form  of  statement,  by  a  divided 
court  in  the  great  case  of  Lux  vs.  Haggin  (69  Cal.  255) 
decided  in  1886." 

The  Master  then  calls  attention  to  the  fact  that 
in  certain  substantial  respects  the  application  of  the 
riparian  doctrine  has  undergone  extension  and  modi- 
fication since  the  Lux  v.  Haggin  case  was  decided. 
It  has  been  extended  to  apply  to  underground  waters 
and  as  against  an  appropriator  from  a  stream  to  the 
owner  of  non-riparian  land  overlying  gravel  supplies 
fed  by  that  stream.  It  has  been  modified  so  as  to 
restrict  the  riparian  right  to  limits  defined  by  actual  or 
possible  beneficial  uses  upon  the  riparian  land.  After 
further  discussing  the  rights  of  the  riparian  owner  the 
Master  continues : 

"I  have  reviewed  the  law  of  this  state  underlying  the 
anomalous  situation  arising  from  the  existence  of  two  rad- 


THE     VALUE     OF     A     WATER     RIGHT  111 

ically  inconsistent  systems  of  water  law  as  a  basis  for  con- 
cluding that  in  valuing  a  right  founded  on  appropriation  we 
will  reach  correct  and  consistent  results  if  we  disregard  all 
attempted  distinctions  drawn  from  controversies  between 
riparian  proprietors  and  appi-opriators;  in  other  words, 
value  the  right  as  if  the  riparian  law  had  never  been  in 
effect." 

Without  attempting  to  follow  the  reasoning  of 
the  Master  at  the  full  length  at  which  presented  in  the 
report,  it  may  be  stated  that  in  conformity  with  the 
view  held  by  the  courts  that  fair  value  must  be  the 
starting  point  when  the  sufficiency  of  earnings  is  in 
question,  the  Master  holds: 

"That  the  fair  market  value  of  plaintiff's  rights  of 
diversion,  as  a  whole,  during  the  respective  years  here  in 
question,  is  the  proper  standard  of  valuation  for  rate  fixing 
purposes;  that  the  extent  of  the  right  is  to  be  measured  by 
the  extent  of  its  utilization,  that  is,  the  yearly  supply  to 
San  Francisco  in  any  year,  less  the  amount  derived  from 
the  Pleasanton  sources"  (underground  waters);  "that  the 
Pleasanton  supply  is  properly  included  by  an  allowance,  in 
the  capital  value,  of  the  market  value  of  the  Pleasanton 
lands  as  a  whole." 

Giving  weight  to  the  evidence  submitted  in  this 
rate  case  including  the  facts  in  a  local  recent  trans- 
action which  included  the  right  to  1,000,000  gallons 
of  water  per  day  and  to  the  findings  of  Judge  E.  S. 
Farrington  in  the  earlier  Spring  Valley  Water  Com- 
pany rate  case  in  which  a  value  of  about  $63,500  per 
million  gallons  of  daily  delivery  was  found  for  1903, 
the  Master  reaches  the  conclusion  that  the  unit  water 
right  value  to  be  applied  to  the  actual  draft  of  water 
from  the  various  sources  of  supply  in  use  by  the 
Spring  Valley  Water  Company  was  $75,000  per  mil- 
lion gallons  per  day  in  the  years  1907-8  and  1908-9; 
$80,000  in  the  years  1909-10'and  1910-11;  $85,000  in 
the  years  1911-12  and  1912-13  and  $90,000  in  the  years 
1913-14  and  1014-15.  This  valuation  applies  to  amounts 
of  water  ranging  from  26.5  million  gallons  per  day  in 
1906-7  to  34  million  gallons  per  day  in  1914-15.  It 
does  not  apply  to  from  5  to  7  million  gallons  of  water 
per  day  obtained  from  the  Pleasanton  wells  whose 


112  PUBLIC     UTILITY     RATE     FIXING 

value  was  included  by  the  Master  in  the  market  value 
of  the  Pleasanton  lands  whose  ownership  was  acquired 
to  secure  the  water. 

Comments  Prompted  by  the  Spring  Valley  Water 
Company  Rate  Case 

In  the  light  of  the  findings  of  water  right  values 
by  the  standing  Master  of  Chancery,  in  the  Spring 
Valley  Water  Company  rate  case,  as  cited  in  the  pre- 
ceding pages,  some  additional  comments  on  the  mar- 
ket value  of  water  rights  with  special  application  to 
conditions  near  San  Francisco  and  in  California  gen- 
erally may  not  be  out  of  place. 

Comparison  with  Other  Water  Rights 

The  value  of  water  rights  elsewhere  than  near  the 
Bay  of  San  Francisco  is  not  the  measure  of  the  value 
of  the  water  rights  in  use  for  supplying  San  Francisco 
with  water.  Nevertheless,  the  prices  actually  paid  for 
water  elsewhere  in  this  state  and  particularly  the  high- 
est prices  paid,  are  elements  for  consideration  in  ascer- 
taining the  market  value  of  water  applied,  as  is  the 
water  of  the  Spring  Valley  Water  Company,  to  the 
highest  use  to  which  water  can  be  applied.  The 
amount  thus  paid  is  an  indication  of  what,  under  cer- 
tain conditions,  the  person  having  use  for  water  consid- 
ers the  same  to  be  worth.  This  statement  applies  not 
alone  to  the  right  to  take  water  at  its  source  but  also 
to  the  developed  water  supply.  It  is  generally  true 
that  when  a  comparison  of  general  value  is  made  in 
any  locality,  the  developed  water  offers  a  better  basis 
of  comparison  than  the  right  to  take  water  at  its 
source. 

In  comparing  a  water  right  which  is  to  be  valued 
with  a  water  right  whose  value  is  known,  due  allow- 
ance must  be  made  for  all  attendant  circumstances. 
The  comparison  would  be  futile  if  in  the  one  case  the 
necessity  of  using  the  water  in  question  is  paramount 
while  in  the  other,  alternative  supplies  are  available. 

The  recognized  value  of  undeveloped  water, — 
$1000  to  $2000  and  more  per  miner's  inch — in  Southern 


E     I 


THE     VALUE     OF     A     WATER     RIGHT  113 

California  for  the  irrigation  of  citrus  fruits  and  like 
products  which  yield  a  good  profit  to  the  growers,  does 
not  establish  the  market  value  of  water  rights  used  for 
the  same  purpose  in  localities  where  water  is  abundant. 

Neither  is  there  any  close  relation  between  this 
value  and  the  value  of  the  right  to  use  water  for  do- 
mestic purposes.  Here,  too,  the  question  of  the  avail- 
ability of  alternative  sources  of  supply  is  to  be  consid- 
ered and  the  relative  cost  of  their  development,  as  also 
the  relation  which  the  amount  of  water  in  use  and  in 
future  demand  bears  to  the  total  amount  of  water 
available  at  the  source. 

The  great  difference  that  usually  prevails  in  the 
cost  of  developing  and  delivering  water  generally  in 
larger  amount  for  irrigation,  when  compared  with  the 
cost  of  developing  and  distributing  the  water  required 
in  any  community  for  domestic  use,  makes  it  difficult 
to  establish  any  definite  relation  betwreen  water  right 
values  in  the  two  cases.  Even  when  water,  if  aban- 
doned for  domestic  use,  would  be  required  for  irriga- 
tion, its  secondary  value  for  the  latter  purpose  can  not 
be  made  the  measure  of  the  market  value  which  it  has 
by  reason  of  its  being  required  for  domestic  purposes. 
Any  water  right  value  which  can  in  such  a  case  be 
determined  from  the  highest  inferior  demand  for  the 
wrater,  as  for  example,  the  assumed  agricultural  use, 
is  the  residual  value  of  the  water  right.  It  is  that  value 
upon  which  a  return  could  be  realized  if  domestic  use 
were  abandoned.  It  is  a  lower  limit  of  the  value  of 
the  water  right. 

\Yhen  by  reason  of  the  growth  of  a  community 
new  sources  of  water  are  added  to  those  already  in 
use  for  its  supply,  the  question  naturally  arises  as  to 
the  proper  procedure  to  be  adopted  in  valuing  the  sev- 
eral water  rights  which  are  essential  to  the  operation 
of  the  water  works  system.  It  is  evident  that  in  such 
circumstances  the  water  at  first  in  use,  by  reason  of  its 
proximity,  may  have  strategic  advantages,  or,  which 
is  quite  as  likely  to  be  the  case,  it  may.  due  to  danger 
of  contamination  or  for  other  reasons,  be  subject  to 
earlv  abandonment.  The  combination  of  several 


114  PUBLIC     UTILITY    RATE     FIXING 

sources  of  supply  in  one  system  may  be  the  result  of 
a  combination  of  two  or  more  developments  under  sep- 
arate ownership,  or  it  may  be  the  result  of  progressive 
development  under  single  ownership.  The  various 
water  rights  which  are  thus  combined  in  a  single  sys- 
tem thereby  lose,  to  a  large  extent  at  least,  their  iden- 
tity. When  the  market  value  of  such  a  combination  of 
water  rights  is  to  be  determined,  and  no  good  reason 
is  apparent  why  they  should  be  treated  separately,  as 
when  abandonment  of  one  or  the  other  is  prospective, 
the  w*ater  rights  of  a  water  works  system  to  the  extent 
that  they  are  in  use,  may  be  considered  in  the  aggre- 
gate. This  has  been  done  by  the  Master  in  this  rate 
case.  In  such  circumstances,  however,  the  cost  or  the 
sacrifice  made  in  acquiring  certain  of  the  water  rights 
may  become  an  aid  in  estimating  the  value  of  the  water 
rights  in  the  aggregate. 

Mutual  Irrigation  Water  Company  Stock  Sales  as  an 
Aid  in  Determining  the  Value  of  Water  Rights 

The  selling  price  of  the  stock  of  mutual  water 
companies  which  are  in  business  solely  for  the  purpose 
of  supplying  water  for  irrigation  to  the  lands  of  the 
stockholders,  may  legitimately  be  used  in  determining 
the  market  value  of  irrigation  water  rights.  In  the 
case  of  such  organizations  it  is  possible,  provided  that 
all  expenditures  have  been  proper  and  reasonable  and 
that  cost  records  have  been  properly  kept,  or  cost  of 
reproduction  can  be  fairly  ascertained,  to  make  a  com- 
parison between  the  outlay  which  may  reasonably  be 
assumed  to  have  been  incurred  in  the  installation  of 
the  works  which  make  the  delivery  of  the  water  to  the 
stockholder  possible  and  the  market  value  of  the  water 
stock.  If  this  market  value,  which  will,  of  course,  be 
affected  by  the  cost  of  operation,  exceeds  the  cost  of 
the  irrigation  system,  the  difference  will  represent  the 
market  value  of  the  water  right.  This  is  a  broad 
statement  of  a  general  principle.  Each  separate  case 
will  require  special  consideration  and  no  individual 
transactions  can  be  accepted  as  conclusive  evidence  of 
the  value  of  a  water  right  in  question.  By  giving  con- 


THE     VALUE     OF     A     WATER     RIGHT  115 

sideration,  however,  to  a  number  of  mutual  water 
companies  and  determining  for  each,  from  stock  trans- 
fers or  otherwise,  the  value  of  the  right  to  take  water 
at  its  source,  a  fair  idea  can  generally  be  obtained  of 
the  amount  which  the  irrigator  is  willing  to  pay  for 
water  rights.  It  is  more  likely,  however,  that  there 
will  be  some  approximation  to  uniformity  in  the  value 
of  the  developed  water  at  the  point  of  delivery  when 
a  number  of  canals  in  the  same  region  under  the  same 
soil,  climatic  and  crop  conditions,  are  compared  (pro- 
vided that  there  remains  under  each  canal  unirrigated 
land  seeking  water),  than  that  there  will  be  anything 
like  uniformity  in  the  net  water  right  values  of  the 
same  canals. 

There  is  no  reason  apparent,  under  such  circum- 
stances, why  under  the  same  charges  for  operation 
and  the  same  reliability  of  service,  the  water  at  the 
field  or  place  of  use  should  have  a  value,  in  the  case  of 
the  concern  whose  investment  to  secure  the  water  is 
small,  different  from  the  value  which  is  conceded  to 
the  water  at  the  field  from  another  concern  whose 
investment  to  secure  the  water  has  been  large.  The 
first  of  these  concerns  may  show  a  high  net  water  right 
value  while  the  second  with  water  possibly  from  the 
same  source  shows  a  low  net  water  right  value.  Both 
concerns  may,  notwithstanding  wide  departures  from 
average  values,  help  to  determine  the  regional  value  of 
the  privilege  to  use  water  for  irrigation.  The  differ- 
ence in  the  quantity  of  water  in  use  by  two  such  canals 
may  make  it  desirable,  however,  to  assign  different 
weights  to  the  results  thus  ascertained  if  therefrom  a 
conclusion  is  to  be  drawn  as  to  the  probable  market 
value  of  a  third  water  right.  Usually  the  cost  of  works 
for  the  delivery  of  water  to  the  place  of  use  is  greatest 
per  unit  of  quantity  in  the  case  of  the  concern  whose 
water  output  is  the  smallest.  Consequently,  when  a 
water  right  value  is  to  be  determined,  there  may  be 
some  advantage  in  weighting  any  ascertained  market 
values  for  separate  canal  or  water  works  system  ac- 
cording to  the  relation  which  the  amount  of  water  sup- 
plied by  each  bears  to  the  quantity  covered  by  the 


116  PUBLIC     UTILITY     RATE     FIXING 

water  right  whose  value  is  in  question.  Results  have 
been  thus  weighted  for  example  in  testimony  submit- 
ted to  the  Master  in  the  Spring  Valley  Water  Com- 
pany rate  case  by  Mr.  F.  C.  Herrman  in  combining  the 
Livermore  sale,  the  Beckwith-Coult  sale,  and  the 
Phillips-Osborn  sale  of  which  the  first  covers  1,000,000 
gallons  of  water  per  day  and  the  others  only  2000  and 
1000  gallons  per  day  respectively.  He  gives  the  average 
cost  for  the  aggregate  amount  of  water.  Though  this 
combination  has  but  little  value,  because  two  very 
small  amounts  of  water  obtainable  from  springs  and 
wells  for  residential  use  are  combined  with  a  relatively 
large  supply  to  be  utilized  for  a  town  supply,  never- 
theless, it  illustrates  a  method  of  combination  which 
may  under  certain  conditions  throw  additional  light 
upon  the  problem  of  ascertaining  water  right  value. 

If  a  similar  procedure  had  been  followed  by  Mr. 
Herrman,  Mr.  Geo.  G.  Anderson  appearing  for  the 
Water  Company  and  Mr.  C.  H.  Lee  appearing  for  the 
City  of  San  Francisco  in  the  discussion  of  the  conclu- 
sions drawn  from  mutual  water  company  stock  sales, 
cited  by  them,  in  the  same  rate  case,  some  further  light 
would  have  been  thrown  upon  the  value  of  water  rights 
in  the  regions  and  under  conditions  of  use  as  explained 
in  their  testimony.  It  would  certainly  be  desirable  to 
know  in  each  case  to  what  amount  of  water  the  ascer- 
tained water  right  value  applies.  It  is  to  be  noted  that, 
as  an  index  of  the  value  of  water  rights  for  the  highest 
use  to  which  water  can  be  put  and  in  localities  where 
the  demand  is  for  the  full  utilization  of  all  available 
water,  only  those  examples  need  be  taken  into 
account  for  comparison,  in  which  the  water  right 
values  appear  relatively  high  - —  all  others  may  be 
dismissed  from  consideration.  The  lists  submitted  by 
Mr.  Lee,  who  appeared  for  San  Francisco,  might  have 
been  extended  to  include  many  more  mutual  water 
companies  operating  in  regions  where  water  is  plen- 
tiful or  where,  due  to  local  conditions,  the  high  market 
value,  prevailing  in  other  sections  of  the  state,  is  not 
yet  realized  and  by  such  extension  the  apparent  arith- 
metical average  values  could  have  been  cut  down  to 


THE     VALUE     OF     A     WATER     RIGHT  117 

almost  any  limit  without  throwing  any  new  light  on 
the  value  of  water  rights  for  domestic  use  at  San  Fran- 
cisco. It  follows  that  such  averages  can  be  of  but 
little  benefit  as  an  aid  in  ascertaining  the  market  value 
of  water,  particularly  when  value  in  another  section  of 
the  state  is  in  question  and  the  water  is  required  or 
is  being  used  for  an  entirely  different  purpose.  It  is 
nevertheless  proper  to  give  consideration  to  the  high- 
est values  of  irrigation  water  rights  anywhere  in  Cali- 
fornia because  it  appears  clear  that,  where,  as  in  the 
case  of  the  San  Francisco  Bay  region,  water  is  scarce 
and  is  required  for  domestic  use,  the  market  value  of 
the  water  right  might  reasonably  be  expected  to  be 
higher  than  elsewhere  in  the  state  for  irrigation  use. 
The  demand  for  the  utilization  of  the  available  sources 
of  water  on  both  sides  of  San  Francisco  Bay,  in  rela- 
tion to  their  yield,  is  probably  quite  as  insistent  as 
anywhere  else  in  the  state.  Furthermore,  the  nature 
of  the  demand  for  water  is  of  a  higher  order  near  great 
centers  of  population  than  in  the  farming  region.  As 
has  been  stated  in  a  preceding  article,  the  demand  for 
domestic  use  is  an  imperative  demand  while  for  all 
other  purposes  the  demand  ceases  when  it  is  no  longer 
profitable  to  use  the  water.  Such  considerations  as 
these  would  be  weighed  by  a  seller  or  a  purchaser 
of  water  rights  near  San  Francisco  and  would  have 
more  or  less  effect  upon  their  conclusions  relating  to 
market  value  even  though  no  direct  method  can  be 
found  of  making  the  value  of  water  somewhere  in 
Southern  California  a  standard  of  value  in  any  other 
locality.  Water  right  values  elsewhere  in  this  state, 
even  where  water  is  used  for  other  than  domestic 
purposes,  are  not  therefore  to  be  ruled  out  of  consid- 
eration altogether. 

The  Enhanced  Value  of  Irrigated  Land  in  Relation 
to  the  Value  of  Water  Rights 

Some  reference  has  been  made  in  the  evidence 
presented  in  the  Spring  Valley  Water  Company  rate 
case  to  the  enhanced  value  of  land  as  a  means  of  deter- 
mining the  value  of  water  rights  in  communities  where 


118  PUBLIC     UTILITY    RATE     FIXING 

the  crop  return  can  be  increased  by  irrrigation.  It  is 
difficult  to  establish  the  relation  between  these  two 
elements.  When  the  farmer  has  made  an  investment 
to  secure  water  and  finds  that  the  increase  in  the  net 
crop  output  of  his  farm  is  greater  than  the  annual  cost 
of  the  water,  including  interest  on  this  investment,  he 
can  form  some  opinion  of  the  value  which  the  use  of 
water  has  added  to  the  farm.  If  the  capitalized  in- 
crease of  crop  output  exceeds  his  investment  for  water, 
he  has  made  a  profit  and  this  profit  can  be  used  as  a 
basis  for  approximating  the  net  worth  to  him  of  the 
water  right. 

The  net  water  right  value  from  the  standpoint  of 
the  irrigator  is  the  capitalization  of  profit  resulting 
from  the  use  of  water  in  excess  of  interest  on  the 
amount  which  he  has  invested  in  securing  it.  While 
this  net  value  may  be  but  small,  the  gross  value  of  the 
water,  or  what  the  irrigator  would  expect  to  get  if  he 
parted  with  the  right  to  use  it  and  no  alternative  sup- 
ply were  available  to  him,  would  be  this  capitalized 
profit  plus  his  investment  in  the  water. 

The  question  may  well  be  asked  when  water  is 
taken  for  a  higher  use,  how  the  sacrifice  of  the  land- 
owner who  has  a  water  right  which  can  be  utilized 
for  irrigation,  but  which  has  never  been  put  to  use, 
compares  with  the  sacrifice  which  another  landowner 
makes  who  has  actually  put  the  water  to  use  on  his 
land.  In  the  case  of  the  second  landowner  it  may  be 
that  the  profit  resulting  from  the  use  of  the  water  is 
not  large.  If  it  were  otherwise,  the  first  landowner 
would  probably  not  have  allowed  his  water  to  remain 
unused.  Assuming  that  there  is  some  definitely  ascer- 
tainable  profit,  however,  then  this  prospective  profit, 
suitably  discounted,  can  be  made  the  measure  of  the 
sacrifice  which  the  first  owner  would  make  if  he  gives 
up  his  water  right,  and,  as  already  stated,  this  profit 
plus  the  cost  of  the  second  landowner's  plant  would 
measure  the  second  landowner's  sacrifice.  Neither  the 
former  nor  the  latter  sacrifice,  both  possibly  represent- 
ing payments  for  water  rights,  taken  singly,  represent 
the  market  value  of  water  rights  and  yet  both  such 


THE     VALUE     OF     A     WATER     RIGHT  119 

determinations  of  value  may  deserve  consideration 
when  the  market  value  of  water  rights  involving  the 
abandonment  of  established  or  prospective  uses  of  the 
water,  is  to  be  determined. 

The  Obligation  to  Supply  Water  at  Less  than  Cost 

The  demonstration  to  show  that  the  sacrifice  made 
in  delivering  water  at  less  than  cost  in  return  for  a 
water  right  is  to  be  taken  into  account  in  the  same 
way  as  cash  expended,  can  be  made  as  follows : 

Assume  that  in  order  to  secure  a  water  supply  of 
1,000,000  gallons  per  day  from  a  certain  creek,  it  is 
necessary  to  furnish  free  of  cost  a  second  million  gal- 
lons per  day  to  the  original  owner  of  the  creek  water 
right.  Let  it  be  assumed  that  it  costs  $200,000  to  make 
the  development  and  that  the  annual  cost  of  operation, 
exclusive  of  interest,  is  $10,000.  If  the  cost  of  develop- 
ing only  1,000,000  gallons  per  day  would  have  been 
$150,000  and  the  cost  of  operation  $7,500,  then  the 
water  right  represents  a  sacrifice  made  by  the  owner: — 

In   capital   invested    ($200,000  —  150,000=  $50,000 

In  operating  expenses  (10,000  —  7500) 

=  $2500  capitalized  at  6% 41,700 


Total,  $91,700 

In  order  to  meet  this  sacrifice,  with  only  a  bare 
interest  return  on  the  investment,  the  earnings  on  the 
sale  of  1,000,000  gallons  of  water  per  day  should  be: 

Interest  at  6<7r  =$12,000 

Operating  expenses  =    10,000         $22,000 


If  there  had  been  no  sacrifice  to  secure  the  water 
right  then  the  necessary  earnings  would  have  been  : — 

Interest  at  67r  =    $9,000 

Operating  expenses  =      7,500         $16,500 


The  difference  between  $22,000  and  $16,500,  cap- 
italized at  ()c/c  is  again  $91,700.  The  rate-pavers  are 
required  to  contribute  a  return  on  the  sacrifice  which 
is  made  to  secure  the  water  which  they  get,  just  as 
though  this  sacrifice  had  been  represented  by  a  cash 
investment. 


120  PUBLIC     UTILITY     RATE     FIXING 

If  there  were  two  concerns  in  operation,  the  one 
subject  to  the  water  burden  and  the  other  also  supply- 
ing 1,000,000  gallons  of  water  per  day,  and  at  the  same 
rates,  but  not  subject  to  a  water  burden,  the  advantage 
in  favor  of  the  latter  would  be  estimated  as  follows : 

Smaller  operating  expenses  by  $2500 

Interest  at  6%   on  $50,000  smaller  investment  =.    3000 


Total  advantage  in  net  revenue 

This,  when  capitalized,  represents  the  excess  of 
value  over  the  capital  invested.  At  6%  interest  this 
excess  amounts  to  $91,670.  This  represents  the  advan- 
tage which  the  concern  operating  without  the  water 
burden  would  have  over  the  other.  It  is  equal  to  what 
it  cost  the  other  concern  to  secure  its  water  rights. 
The  necessity  of  using  the  water  of  both  concerns  has, 
of  course,  been  assumed.  When  the  market  value  of 
water  rights  is  in  question  the  obligation  which  'has 
been  assumed  to  furnish  water  free  or  at  less  than  cost 
to  the  former  owners  of  adverse  rights  can  thus  be 
made  an  aid  in  solving  the  problem. 

All  that  has  been  said  about  market  value  is,  of 
course,  apart  from  the  other  fundamental  question 
relating  to  whether  or  not  market  values  should  appear 
in  the  rate  case.  This  question  has  elsewhere  in  these 
articles  received  full  consideration. 


THE     RATE     OF     RETURN  121 


CHAPTER  VII 

THE  RATE  OF  RETURN 

Protection  of  the  Investment 

The  business  of  every  public  service  concern  is 
subject  to  regulation  and  control  by  properly  consti- 
tuted authority.  It  will  not  be  going  too  far  to  say  that 
any  business  which  is  monopolistic  in  character  should 
be  considered  subject,  at  the  will  of  the  public,  to  like 
regulation  and  control,  even  though  there  are  as  yet, 
only  the  first  symptoms  apparent  that  there  may  in 
time  be  a  full  exercise  of  the  public's  right  in  this  dir- 
ection. But  whenever  the  public  controls  and  regu- 
lates a  business,  particlarly  in  the  matter  of  fixing  the 
price  of  the  output,  it  is  fundamental  that  any  legiti- 
mate investment  made  for  the  benefit  of  the  public 
must  be  adequately  protected.  Whatever  sacrifice  the 
owner  of  a  public  utility  makes  should  be  of  a  tem- 
porary character  only.  He  should  never  be  compelled 
to  operate  under  conditions  that  leave  the  question  of 
protection  of  his  legitimate  investment  in  doubt. 
Whenever  this  protection  is  not  assured,  the  element 
of  risk  grows  as  a  factor  to  be  considered,  and  in  some 
way  or  other  the  public  must  meet  the  resultant 
higher  cost  of  the  commodity  or  service.  The  time 
has  not  yet  come  when  the  public  is  willing  to  go  so 
far  as  to  guarantee  to  the  owner  of  the  public  utility 
full  protection  against  loss ;  but  there  are  those  who 
believe  that  it  might  be  wise  to  extend  such  full  pro- 
tection, at  least  in  the  case  of  some  of  the  more  im- 
portant public  utilities.  That  this  would  in  no  small 
measure  simplify  the  matter  of  rate  fixing  is  selt- 
evident.  Meanwhile  the  rate  of  return  to  which  the 
public  utility  owner  is  fairly  entitled  must  be  con- 
sidered to  be  affected  more  or  less  by  risk. 

The  fundamental  requirement  when  the  earnings 
of  a  public  utility  are  to  be  limited,  is,  therefore,  as 
has  been  stated,  that  they  be  adequate  to  afford  pro- 


122  PUBLIC     UTILITY     RATE     FIXING 

tection  to  the  investment.  But  the  owner  of  a  public 
utility  is  entitled,  by  right,  to  something  more  than 
a  mere  protection  of  investment.  He,  by  reason  of  his 
experience  and  the  credit  which  he  and  his  associates 
and  backers  command,  makes  it  possible  for  the  com- 
munity to  enjoy  the  advantages  of  transportation,  of 
adequate  water  supply,  of  telephone  and  telegraph  fa- 
cilities, of  lighting  and  heating  opportunities,  which 
without  his  help,  might  have  to  be  long  deferred.  The 
establishment  of  the  public  utility,  due  to  his  enter- 
prise, immediately  adds  value  to  the  land  holdings  and 
other  property  within  the  area  served  and  in  lesser 
degree,  also  to  surrounding  lands  and  property  within 
the  broader  zone  in  which  the  property  values  are  in 
any  way  affected  by  the  growth  of  the  community 
which  is  served  by  the  utility.  The  owner  of  the 
public  utility  is  therefore,  a  public  benefactor  and 
should  be  compensated  not  merely  as  an  agent  of-  the 
public  would  be  compensated,  but  he  should  also  get 
some  reward  for  adding  to  the  unearned  increment  of 
other  property  owners.  He  may  in  some  instances 
profit  as  owner  of  appreciating  property  such  as  real 
estate,  but  in  other  instances  full  compensation  should 
be  otherwise  arranged  for,  as  for  example,  by  allowing 
him  to  share  in  the  general  prosperity  to  which  his 
financial  resources  have  contributed. 

How  this  compensation  should  be  made,  what  its 
amount  should  be,  and  what  factors  should  be  taken 
into  consideration  when  rates  are  to  be  fixed  has  been 
discussed  in  the  previous  articles  of  this  series.  It 
has  been  pointed  out  that  to  protect  the  investment 
adequately  and  fairly,  a  proper  determination  of  this 
investment  should  be  made  and  that  undiminished  by 
depreciation  this  investment  will  be  the  "natural  rate 
base."  It  has  also  been  pointed  out  that  the  compen- 
sation for  management,  hazard  and  participation  in 
general  prosperity  can  be  more  satisfactorily  brought 
into  relation  with  the  volume  of  business  than  into 
relation  with  any  rate  base.  There  remain  to  be  con- 
sidered what  the  fair  rate  of  return  should  be  when 
viewed  from  various  standpoints. 


THE     RATE     OF    RETURN  123 

In  the  case  of  any  "going  concern"  which  is  so 
firmly  established  that  indefinite  life  and  certainty  of 
continuous  earning  capacity  may  be  assumed,  the 
business  world  recognizes  as  adequate  some  generally 
acceptable  rate  of  return  on  the  capital  legitimately 
invested  in  the  enterprise,  supplemented  by  what  may 
be  called  profit,  which  ordinarily  will  be  considered 
in  its  relation  to  the  volume  of  business. 

If  the  amount  by  which  the  dependable  annual 
gross  earnings  exceed  the  operating  expenses  (the 
latter  being  here  taken  exclusive  of  interest  on  the 
invested  capital)  be  capitalized  at  an  interest  rate, 
based  on  an  acceptable  rate  of  return  as  above  defined, 
the  aggregate  value  of  the  enterprise  will  be  found. 
This  will  cover,  in  the  case  of  the  successful  property, 
not  alone  the  value  of  physical  elements  and  the 
amounts  actually  expended  for  rights,  privileges  and 
easements  but  also  the  other  elements  of  intangible 
value  such  as  good  will,  going  value,  water  rights, 
concessions,  patents  and  the  like. 

Other  Factors  Besides  the  Rate  of  Return  on  the 
Legitimate  Investment 

It  is  an  interesting  study  to  determine  for  any 
class  of  enterprise,  be  they  of  a  private  character  or 
in  the  public  service  class,  what  should  be  considered 
a  fair  rate  of  return  on  an  investment  adequate  to 
establish  an  enterprise  of  the  class  in  question  and 
what  would  be  a  reasonable  profit  in  excess  of  the 
earnings  that  would  otherwise  just  cover  this  rate  of 
return. 

Unfortunately  there  has  no  attempt  been  made 
heretofore  to  thus  subdivide  the  gross  profits  of  public 
service  concerns.  It  has  seemed  sufficient  to  say  that 
a  return  of  7  or  8  or  9  per  cent  per  annum  as  the  case 
may  be,  computed  on  the  value  of  the  property,  is  a 
fair  return.  The  value  which  is  created  by  the  net 
earnings  is  quite  illogically  made  the  base  to  be  used 
in  determining  what  the  rate  of  return  is. 

How  much  better  would  it  be  to  make  the  separa- 
tion, which  will  certainly  appeal  to  the  business  man, 


124  PUBLIC     UTILITY     RATE     FIXING 

as  above  indicated  into  interest  on  the  capital  in  the 
business  venture  and  profit  expressed  in  relation  to 
the  volume  of  business. 

When  as  in  the  case  of  water-works  the  amount 
of  capital  invested  is  ordinarily  large  in  comparison 
with  the  annual  income  (volume  of  business),  not  in- 
frequently 10  to  1,  the  defects  of  the  ordinary  proced- 
ure are  not  so  striking  as  in  the  case  of  the  concern 
which  does  a  large  annual  business  on  a  small  invest- 
ment. In  the  latter  case  the  cost  of  money  to  the 
owners  for  use  in  the  enterprise  may  be  no  greater 
than  in  the  former  and  yet,  if  there  were  no  return  in 
excess  of  what  would  be  a  fair  return  on  relatively 
large  capital  investments,  the  enterprise  would  not  be 
undertaken. 

There  is,  therefore,  no  standard  fair  rate  of  re- 
turn that  can  be  prescribed  or  that  will  prove  accept- 
able unless  the  same  be  applied  to  investment  and  be 
supplemented  with  a  profit  which  as  stated  should  bear 
some  relation  to  the  annual  volume  of  business. 

But  even  when  thus  separated  into  two  parts,  the 
net  earnings  which  should  be  considered  adequate  by 
a  prudent  business  man  are  not  determinable  by  any 
fixed  standard.  This  is  particularly  true  of  the  profit 
item  when  taken  apart  from  and  as  an  addition  to 
interest  on  the  capital  reasonably  and  properly  in- 
vested. This  profit  item  will  naturally  fluctuate  with 
the  degree  of  risk  and  with  the  public's  estimate  of 
general  prosperity,  and  with  the  value  that  may  attach 
to  business  skill,  integrity  and  responsibility  involved 
in  providing  the  plant  and  the  business  organization 
and  directing  its  operation. 

If  money  at  interest  in  savings  banks  or  invested 
in  municipal  or  government  securities  regarded  as 
safe  brings  an  interest  return  of  4^  per  annum,  the 
money  placed  in  industrial  enterprises  or  into  estab- 
lished and  demonstrated  public  utilities  should  bring 
a  return  of  at  least  5  or  6  per  cent.  A  fair  return 
would  be  6  or  7%  provided,  of  course,  that  this  return 
is  free  from  the  hazards  of  the  business  and  from  the 


THE     RATE     OF     RETURN  125 

responsibility  of  management.  When  an  enterprise  is 
in  sucessful  operation  the  owner  thereof  would  expect 
to  get  money  when  he  needs  it  at  these  rates  and  the 
lender  would  want  not  less  than  such  a  return  because 
he,  too,  makes  some  sacrifice  whenever  he  accepts 
paper,  which  may  not  be  readily  negotiable  in  the 
financial  market.  This  being  the  situation,  the  owner, 
himself,  expects  and  is  entitled  to  some  such  a  return 
on  the  money  sacrifice  which  he  has  made  to  establish 
the  business,  or,  if  viewed  from  a  slightly  different 
standpoint,  which  he  or  any  one  else  would  have  to 
make  to  reproduce  and  reestablish  the  business  if  the 
same  were  non-existent.  But  he  would  still  be  inad- 
equately compensated  if  there  were  not  some  addi- 
tional return  in  sight  as  already  explained. 

The  rate  fixing  authorities  have  made  it  a  prac- 
tice, however  undesirable  this  may  be,  of  allowing 
certain  rates  of  return  on  the  value  of  the  public  serv- 
ice properties.  There  is,  in  this  practice,  a  disregard 
of  the  elements  which  deserve  special  consideration. 
Thus  for  example,  the  owner  of  gas  works  or  of  a  plant 
for  supplying  electric  energy  may  be  allowed,  by  rate 
fixing  authorities  to  earn  8%  or  a  little  more  on  the 
so-called  fair  value  of  his  property,  while  if  he  is  in 
the  business  of  supplying  water  for  domestic  use  he 
may  be  held  down  to  6  or  7%. 

Rate  of  Return  Defined 

When  the  question  is  asked — What  is  a  fair  rate 
of  return?- — the  first  point  to  be  determined  will  be 
the  base  to  which  this  rate  is  to  apply.  This  base  may 
be  either  the  investment,  i.  e.,  the  natural  rate  base, 
or,  as  many  would  have  it,  the  value  of  the  property  in 
question.  The  question,  therefore,  should  be  modified. 
It  may  be  put  in  cither  of  the  following  two  forms: 

1.  What  is  a  fair  rate  of  retuz-n  on  the  value  of  the 
property? 

2.  What  is  a  fair  rate  of  return  on  the  capital  legiti- 
mately invested  in  the  enterprise  not  diminished  by 
depreciation   (on  the  natural  rate  base)  ? 

While  the  first  of  these  questions  is  apparently 
illogical  because  value  results  from  earnings,  it  never- 


126  PUBLIC     UTILITY    RATE     FIXING 

theless  deserves  consideration.  The  owner  as  well  as 
the  rate-payer  is  interested  in  knowing  whether  the 
business  falls  into  the  class  of  enterprises  in  which  net 
earnings  may  be  capitalized  at  such  low  percentages 
as  5  or  6  or  whether  capitalization  should  be  at  higher 
rates.  This  is  convenient  and  valuable  information 
but  in  the  matter  of  rate  fixing  leads  nowhere  until 
the  limit  to  be  placed  on  earnings  has  been  otherwise 
determined.  The  interest  rate  of  capitalization  will 
vary  according  to  the  nature  and  the  magnitude  of  the 
enterprise.  It  will,  when  ascertained,  be  applied  to 
the  net  earnings  which  should  include  allowances  for 
risk,  for  management,  and  for  a  share  in  general  pros- 
perity. This  interest  rate  is  not  to  be  confounded  with 
the  rate  of  return  on  the  investment,  which  in  the 
case  of  the  successful  business  will  always  be  a  higher 
rate,  because  in  the  successful  business  the  investment 
is  less  than  value. 

The  question  in  its  second  form  will  be  vital  so 
long  as  the  rate  base  alone,  without  regard  to  volume 
of  business,  is  taken  into  account,  because  upon  the 
correct  answer  depends,  not  alone  the  protection  of  the 
owner's  investment  in  the  enterprise,  but  also  the  de- 
gree of  encouragement  to  be  given  to  others  to  place 
their  financial  resources  at  the  disposal  of  the  public 
by  engaging  in  similar  ventures. 

Strictly  speaking,  therefore,  and  considered  from 
the  standpoint  of  the  owner,  the  rate  of  return  would 
be  the  amount  per  hundred,  or  the  amount  on  some 
other  unit,  of  the  net  earnings  in  relation  to  the  cap- 
ital which  has  actually  been  invested  or  which  in  the 
judgment  of  the  public  should  be  assumed  to  have 
been  invested  in  the  enterprise.  The  net  earnings  in 
the  sense  here  used  represent  the  excess  of  the  income 
over  operating  expenses,  the  latter  expression  being 
used  in  its  broadest  sense,  including  a  proper  allow- 
ance for  replacements.  In  the  successful  venture  the 
rate  of  return  will  be  such  that  the  investment  of  cap- 
ital therein  will  appear  attractive.  When  the  enter- 
prise has  been  long  established,  well  managed  and  is 
non-competitive,  this  rate  may  be  relatively  low  with- 


THE     RATE     OF     RETURN  127 

out  mitigating  against  the  successful  operation  thereof, 
while,  in  the  case  of  a  new  venture,  the  rate  of  return, 
immediate  or  prospective  or  both  immediate  and  pros- 
pective, should  be  relatively  high  in  order  that  the  in- 
vestment of  capital  may  be  encouraged  and  not  re- 
pelled. 
The  Obligation  of  the  Public  When  It  Regulates 

The  public  has  the  right,  now  hardly  questioned, 
to  regulate  rates,  and  thereby  to  limit  the  rate  of  re- 
turn of  the  public  utility.  It  has  already  been  stated 
that  the  extension  of  this  power  of  regulation  to  the 
affairs  of  persons  and  corporations  whose  business  has 
grown  to  such  proportions  that  they  can  crush  their 
smaller  competitors,  is  fast  coming  to  be  recognized  as 
desirable.  But  when  this  power  is  exercised  whether 
over  the  public  utility,  or  over  trusts  and  corporations 
of  monopolistic  tendencies,  the  question  may  be  asked, 
as  already  intimated,  whether  or  not  the  limitation  of 
earnings  should  not  be  accompanied  by  some  measure 
of  guarantee  that  there  will  be  adequate  earnings, 
either  for  a  definite  period  of  time,  or  for  time  without 
limit.  Probably  no  one  has  yet  gone  quite  so  far  as 
to  hold  that  it  would  be  fundamentally  sound  when 
rates  are  regulated  by  public  authority  to  guarantee  a 
lower  limit  of  net  earnings ;  and  yet  this  is  the  logical 
outcome  of  regulation.  If  such  a  practice  could  obtain 
the  true  agency  relation  would  be  established.  The 
utility  owner  would  then,  in  fact,  be  the  agent  of  the 
community  which  the  utility  serves,  and  therefore 
entitled  to  nothing  for  risk,  nor  for  unearned  incre- 
ment, but  only  to  the  ordinary  return  on  safe  invest- 
ment plus  compensations  for  management.  The  latter 
in  such  a  case  might  be  reasonably  placed  at  2  to  5 
per  cent  of  the  volume  of  business  according  to 
whether  this  volume  is  large  or  small.  This  does  not 
mean  that  a  guaranteed  rate  of  return  could  be  made 
the  same  in  all  parts  of  the  country  and  for  all  utili- 
ties. There  would  always  be  considerable  range  in 
the  degree  of  security  afforded  by  government  or 
municipal  guarantees  of  rates  of  return  and  then,  too, 
the  rates  of  return  on  safe  investments  are  not  everv- 


128  PUBLIC     UTILITY     RATE     FIXING 

where  and  under  all  circumstances  the  same.  It  might 
also  make  a  difference  whether  an  enterprise  is  already 
profitable  or  whether  it  depends  for  profit  on  future 
earnings;  whether  it  is  certain  to  be  ultimately  suc- 
cessful or  whether  there  remains  a  doubt  concerning 
the  wisdom  of  having  afforded  to  it  the  government 
or  community  backing.  And  then  the  question  will 
arise,  whether  efficient  service  can  be  hoped  for  if  the 
element  of  risk  is  entirely  removed.  Would  not  this 
lead  to  carelessness  and  indifference  to  the  disadvan- 
tage of  the  public? 

Regulation  then  should  not  go  too  far,  the  limit  of 
earnings  should  not  be  too  definitely  defined ;  there 
should  remain  the  possibility  of  increasing  profits  by 
efficient  management. 

Rate  of  Return  Illustrations 

How  the  rate  of  return  will  vary  according  to  the 
rate  base  to  which  applied  can  perhaps  be  shown  to 
advantage  by  examples. 

Let  it  be  supposed  that  the  business  of  a  utility 
is  under  consideration  to  which  the  following  facts 
apply  :— 

Investment  (determined  from  cost  and  from  the 

estimated  reproduction  cost) $1,000,000 

Accrued   depreciation _ 200,000 


Investment  less  accrued  depreciation 800,000 

Past  amortization  of  capital uncertain 

Operating    expenses    (including    the  current   re- 
placement requirement)    250,000 

Gross  annual  income  350,000 

Net  annual  income 100,000 

Rate  of  return  applied  to  value  as  it  would  be 

found  if  all  properties  were  new 8% 

Capitalization  of  net  income,  100,000  at8% 1,250,000 

Present  value,  1,250,000  —  200,000 1,050,000 

Going  value,   1,050,000  —  800,000 250,000 

The  'going  value'  as  here  listed  is  the  excess  of 
the  value  of  the  'going  concern'  $1,050,000  over  the 
original  investment  less  depreciation  $800,000.  If  the 
enterprise  were  new  the  comparison  would  be  with 
another  in  exactly  the  same  condition  ready  to  begin 
business  but  not  yet  in  operation  and  the  same  result 


THE     RATE     OF     RETURN  129 

would  be  found.  Going  value  is,  therefore,  independ- 
ent of  accrued  depreciation. 

If  money,  borrowed  for  investment  on  this  enter- 
prise can  be  had  at  6%  interest,  the  owners  will  be  get- 
ting 8% — 6%  =2%  on  the  original  investment  for 
management,  risk,  etc.  which  is  $20,000. 

When,  for  such  a  concern,  rates  are  to  be  fixed, 
the  gross  income,  the  net  income  and  the  value  are  all 
unknown  quantities.  The  procedure  should  then  be 
about  as  follows : 

Required  earnings: 

8%  on  the  original  investment  of  $1,000,000         80,000 

Operating  expenses $250,000 

Allowance  for  management  about  2.5%  and 
and  for  risk  and  profit  about  3%  of  the 
volume  of  business,  say 20,000 


Total  required  earnings $350,000 

The  allowance  here  noted  of  $20,000  for  manage- 
ment, risk  and  profit  capitalized  at  S%  is  $250,000. 
This  will  be  the  'going  value'  of  the  business  created 
by  such  earnings. 

The  natural  rate  base  in  this  illustration  is  $1,000,- 
000,  representing  investment  not  diminished  by  depre- 
ciation. If  the  net  return  be  compared  with  this  rate 
base,  the  rate  of  return  is  found  to  be  10%.  In  fixing 
rates,  it  is  undesirable  to  use  this  relation  because 
there  is  included  therein,  profit  and  compensation  for 
management  and  an  allowance  for  risk  which  as  ex- 
plained should  be  brought  into  relation  to  volume  of 
business.  It  may  be  repeated  that  such  comparison 
with  volume  of  business  is  preferable  to  a  possible 
alternative,  a  comparison  with  the  cost  of  operation, 
for  the  same  reason  that  the  merchant  desires  to  ex- 
press the  profit  in  his  sales  in  percentage  of  his  re- 
ceipts, rather  than  in  relation  to  cost.  This  is  no  doubt 
due  to  the  fact  that  the  sale  price  is  more  stable  and 
subject  to  less  fluctuation  than  cost. 

As  a  second  illustration,  let  it  be  supposed  that 
the  following  facts  relating  to  a  steamboat  business 
have  been  ascertained  : — 


130  PUBLIC     UTILITY     RATE     FIXING 

The  steamboat  cost  new  and  can  be  replaced  for $500,000 

Its  present  value  is  appraised  at 100,000 

There  are  invested  in  other  items  connected  with 

the   business,    lands,   buildings,    wharves,   etc. 

original  cost 500,000 

The  present  value  of  these  other  items  is 300,000 

The  mean  annual  dependable  gross  receipts  are 450,000 

The  operating  expenses  per  annum  including  a  fair 

replacement  increment,  are 250,000 

The  net  return,  therefore 200,000 

The  rate  of  return  on  the  value  of  this  business 

as  value  would  be  found  if  all  properties  were 

new,  should  be,  per  annum 15% 

What  is  the  value  of  the  business? 

What  is  the  value  of  the  good-will?  or  in  case  of 

a  public  utility  and  no  competition,  what  is  the 

'going  value?' 

If  the  steamboat  were  new  the  value  of  the  busi- 
ness would  be  found  by  capitalizing  the  net  earnings 
($450,000— $250,000=  )  $200,000  at  15  per  cent  This 
would  make  the  business  worth  $1,330,000.  But  as 
there  remains  only  $100,000  of  the  original  value  of  the 
steamboat  to  be  made  good  before  the  steamboat  will 
have  to  be  replaced  and  this  is  $400,000  short  of  the 
cost  of  a  new  steamboat,  and  because  the  other  prop- 
erties connected  with  the  business  have  decreased  in 
value  $200,000  (supposed  in  this  case  to  have  been 
covered  by  past  earnings)  the  present  value  of  the 
business  will  fall  ($400,000  -f  $200,000=  )  $600,000 
short  of  the  value  that  would  obtain  if  all  the  proper- 
ties including  the  steamboat  were  new.  Consequently 
the  value  of  the  property  is  $1,330,000  — $600,000  = 
$730,000. 

Purchased  at  this  price  the  new  owner  would  ap- 
parently be  earning  $200,000  annually  on  an  invest- 
ment of  $730,000.  His  rate  of  return  would  appear  to 
be  27.4  per  cent  on  this  investment.  But  he  has 
assumed  an  obligation  to  re-invest  in  a  new  steamboat 
when  the  old  one  fails  at  which  time  he  will  have 
earned  only  $100,000  toward  the  cost  of  this  steam- 
boat. He  has  also  assumed  the  obligation  to  keep  in 
repair  and  at  full  efficiency,  buildings  and  wharves 
which  arc  no  longer  new  and  whose  up-keep  will  cost 
more  than  if  they  were  all  new.  He  will  have  assumed 
all  the  obligations  that  went  with  the  original  invest- 


THE     RATE     OF     RETURN  131 

ment  of  $1,000,000  and  can  not  afford  to  pay  more 
than  the  $730,000  for  the  business  without  consenting 
to  a  rate  of  return  on  such  investments  less  than  the 
assumed  $15%  rate. 

The  'good-will'  or  'going  value'  of  the  business  as 
the  case  may  be,  is  found  by  comparing  the  invest- 
ment in  the  business  with  the  value  thereof,  all  prop- 
erties being  assumed  new  (or  by  comparing  present 
value  with  the  investment  decreased  by  accrued  depre- 
ciation). In  this  case  it  will  be  $1,330,000  — $1,000,000 
=  $330,000,  or  $730,000  —  $400,000  =  $330,000. 

If  now  it  is  possible  to  borrow  money  for  invest- 
ment in  this  steamboat  enterprise  at  a  cost  of  7%  per 
annum  and,  for  the  purpose  of  illustration,  it  be 
assumed  that  the  entire  original  investment  of  $1,000,- 
000  has  been  thus  borrowed,  the  owner  would  have  to 
pay  out  as  interest  $70,000  leaving  $200,000— $70,000  = 
$130,000  as  his  compensation  for  management,  as- 
sumption of  hazard,  and  share  in  general  prosperity. 
This  is  equivalent  to  about  30%  on  the  volume  of 
business.  This  rate  is  high  because  the  volume  of 
business  which  has  been  assumed  is  small.  It  should 
be  relatively  high  because  the  steamboat  business  is 
hazardous. 

The  rate  of  return  based  on  the  present  value  is 
found  by  comparing  the  net  income  of  $200,000  with 
the  present  value  $730,000.  It  is  27.4%. 

What  in  the  case  of  this  steamboat  business  is 
the  rate  of  return  expressed  in  relation  to  the  original 
investment? 

The  original  investment  was  $1,000,000.  This  is 
made  up  of  the  value  of  the  physical  properties 
$400,000  plus  the  obligation  to  make  good  the  accrued 
depreciation  of  $600,000  as  required.  The  net  income 
is  $200,000.  The  rate  of  return  on  the  original  invest- 
ment, on  the  natural  rate  base,  is  therefore,  20  per  cent 
per  annum. 

\Yhat  in  the  case  of  the  same  property  is  the  rate 
of  return  expressed  in  relation  to  the  investment  de- 
creased by  accrued  depreciation — i.  e.,  relative  to  the 


132  PUBLIC     UTILITY     RATE     FIXING 

so-called  depreciated  or  present  value  without  inclu- 
sion of  going  value? 

As  the  original  investment  was  $1,000,000  and  the 
accrued  depreciation  is  $600,000  the  present  value,  ex- 
clusive of  'going  value'  is  $400,000  and  the  rate  of 
return  on  this  basis  50%  per  annum. 

These  illustrations  make  plain  the  proposition  that 
the  rate  of  return  varies  according  to  the  base  to  which 
applied  without  affecting  the  essential  element,  the  net 
earnings. 

The  Spring  Valley  Water  Co.  Rate  Case 

On  the  subject  of  the  fair  rate  of  return  in  the 
Spring  Valley  Water  Company  rate  case,*  the  stand- 
ing Master  in  Chancery,  Mr.  H.  M.  Wright,  in  his 
report  filed  with  the  court  in  October,  1917,  says: 

"What  we  desire  to  determine  is  the  fair  rate  of  return 
which  the  capital  already  invested  and  in  fixed  form  in  plain- 
tiff's properties  was  entitled  to  earn  in  the  different  years  in 
question  as  a  reward  for  its  dedication  to  the  public  service. 
The  usual  test  for  determining  that  fair  rate  is, — what  rate 
of  return  would  in  any  such  year  attract  new  capital  to  an 
investment  in  plaintiff's  property  to  provide  additions  or 
extensions  thereto.  I  presume  the  theory  is  that  the  existing 
investor  should  receive  at  any  time  for  the  use  of  his  capital 
already  in  the  enterprise  whatever  a  new  investor  would  de- 
mand in  return  for  new  capital  put  in  alongside  the  existing 
capital, — or,  otherwise  expressed,  the  current  market  rate  of 
money  for  this  purpose.  The  point  of  view  seems  to  me  cor- 
rect and  helpful  and  if  I  mistake  not  is  acceded  to  by  counsel 
for  both  parties." 

"It  is  the  plaintiff's  position  that  a  showing  of  less  than 
7%  per  annum  net  return  is  less  than  a  reasonable  rate.  It  is 
the  city's  position  that  5%  is  'non-confiscatory'  or,  in  other 
words,  reasonable;  it  is  not  in  terms  conceded  that  less  than 
5%  is  unreasonable." 

In  the  case  of  Willcox  vs.  Consolidated  Gas  Co. 
(212  U.  S.  19)  the  U.  S.  Supreme  Court  says  in  refer- 
ring to  factors  which  influence  the  rate  of  return: 

"The  amount  of  risk  in  the  business  is  a  most  important 
factor,  as  well  as  the  locality  where  the  business  is  conducted, 
and  the  rate  expected  and  usually  realized  thereupon,  invest- 
ments of  a  somewhat  similar  nature  with  regard  to  the  risk 
attending  them.  *  *  *  The  less  risk,  the  less  right  to  any 
unusual  returns  upon  the  investments." 

After  stating  that  in  the  case  of  the  Consolidated 
Gas  Company  the  risk  was  "reduced  almost  to  a  min- 


*Spring  Valley  Water  Go.  vs.  San  Francisco  (rate  case). 


THE     RATE     OF     RETURN  133 

imum,  because  future  competition  was  'unthinkable'  " 
and  that  its  business  was  "the  most  favorably  situated 
gas  business  in  America,"  the  Court  says: 

"Taking  all  facts  into  consideration,  we  concur  with 
the  court  below  on  this  question,  and  think  complainant  is 
entitled  to  6%  on  the  fair  value  of  its  property  devoted  to 
the  public  use." 

The  Master  in  the  Spring  Valley  Water  Company 
rate  case,  after  stating  that  this  rate  of  return  applies 
to  New  York  in  1906,  reaches  the  conclusion  that 
under  the  different  circumstances,  particularly  as  to 
the  risks  involved  and  the  difference  in  the  money 
markets  and  rates  of  New  York  and  San  Francisco, 
"a  higher  rate  would  be  proper  for  this  plaintiff  in 
1907-15"  if  6%  was  a  proper  rate  for  the  Consolidated 
Gas  Company  in  New  York  in  1906.  The  Master  then 
reviews  earlier  decisions  in  water  rate  cases  in  Cali- 
fornia showing  rates  of  return  heretofore  allowed  and 
also  the  rates  of  return  on  real  estate  loans  and  on 
stocks  and  bonds,  and  cites  the  testimony  of  expert 
witnesses  and  reaches  the  conclusion : 

"That  the  fair  rate  of  return,  net,  which  plaintiff  was 
entitled  to  earn  during  the  period  1907  to  1915  inclusive,  for 
the  service  of  '(supplying)'  water  to  San  Francisco  and  its 
people,  was  seven  per  cent  per  annum  upon  the  property  val- 
ues as  found  in  this  report.  And  if  the  court  shall  conclude 
that  a  sum  for  going  value  should  not  be  included  in  the 
appraisal  of  capital  in  use,  so  that  the  works  is  valued  prac- 
tically as  a  new  enterprise,  then  I  find  the  fair  rate  to  be 
applied  was  eight  per  cent." 

The  Master  in  reaching  this  conclusion  follows 
the  usual  practice  of  bringing  the  entire  net  earnings 
into  a  percentage  relation  to  the  property  values  in- 
stead of  making  a  subdivision  thereof,  as  the  writer 
points  out  would  be  more  logical.  The  result  would 
be  practically  the  same,  for  example,  in  the  case  of  a 
public  utility  valued  at  $30,000,000,  whose  operating 
expenses  are  $1,200,000  per  annum  when  earnings  are 
to  be  limited,  whether  the  net  income  be  computed  at 
6c/c  on  $30,000,000,  plus  an  allowance  of  lO^r  on  the 
gross  income  of  about  $3,300.000  amounting  to 
($1,800,000 +  $330,000=)  $2,130,000,  or  whether  the 
same  be  computed  at  a  7c/c  rate  of  return  amounting 
to  $2,100,000.  The  desirability  of  the  first  of  these 


134  PUBLIC     UTILITY    RATE     FIXING 

methods  of  determining  the  net  income  to  be  allowed, 
under  which  some  regard  is  had  to  the  volume  of 
business  as  well  as  to  the  natural  rate  base,  has  been 
fully  discussed  in  a  preceding  article  of  this  series. 

In  the  District  Court  of  the  United  States  for  the 
Northern  District  of  California  the  findings  of  the 
Master  in  reference  to  the  rate  of  return,  as  above 
quoted,  did  not  receive  unqualified  approval.  The 
Court  holds  that  while  7  per  cent  may  be  accepted  as 
a  fair  rate  of  return  the  lower  rate  of  6  per  cent  would 
not  be  confiscatory.  Judge  Franklin  H.  Rudkin,  who 
issued  the  decree  of  the  Court,  says  in  this  connection : 

"The  Master  found  that  the  plaintiff  was  entitled 
to  a  return  of  seven  per  cent  on  its  invested  capital 
during  the  several  years  in  controversy  here.  If  this 
is  to  be  deemed  a  mere  finding  that  such  a  rate  of 
return  was  fair  and  reasonable  as  between  the  com- 
pany and  the  water  consumers,  I  have  no  comment  or 
criticism  to  make.  If,  on  the  other  hand,  it  is  to  be 
deemed  a  finding  or  conclusion  that  any  less  rate  of 
return  was  confiscatory  and  violative  of  the  Constitu- 
tion of  the  United  States,  I  must  dissent  therefrom." 
"I  am  of  opinion  that  a  return  of  as  high  as 
six  per  cent  on  the  invested  capital  or  value  of  prop- 
erty devoted  to  the  service  of  the  public,  is  not  confis- 
catory and  violates  no  constitutional  right  of  the  plain- 
tiff."" 

While  it  appears  from  this  quotation  that  the 
Court  does  not  make  a  clear  distinction  between  "in- 
vested capital''  and  "value  of  property"  other  portions 
of  the  Court's  opinion  show  that  application  of  the 
rate  of  return  to  the  value  of  the  property  is  intended. 


THE     RATE     CHEDULE  135 

CHAPTER  VIII 

THE  RATE  SCHEDULE 

Unit  Price  to  Consumers  Not  Uniform 

In  these  articles  on  rate  fixing-  there  has  thus  far 
nothing  been  said  about  the  distribution  to  the  indi- 
vidual rate  payers  of  the  aggregate  charge  for  service 
rendered  or  for  commodity  furnished  by  a  public 
utility.  The  custom  has  become  established  of  making 
the  collections  from  the  rate  payers  practically  the 
sole  source  of  revenue.  The  charges  are  usually  so 
adjusted  when  applied  to  the  individual  rate  payer 
that  they  are  brought  into  relation,  approximately  at 
least  to  the  cost  of  rendering  the  individual  service. 
Equalization  of  the  unit  price  to  all  consumers  can  not 
be  hoped  for.  In  any  group  of  consumers  who  pay 
exactly  the  same  amount  for  equal  amounts  of  service 
the  actual  cost  of  rendering  the  service  to  the  individ- 
ual consumer  may  vary  within  wide  limits.  The  rate 
is  fixed  on  the  average  cost  of  the  particular  service 
to  a  large  number  of  individuals.  Absolute  equaliza- 
tion of  the  relation  of  the  rate  to  the  cost  of  service 
in  each  separate  case  is  also  out  of  the  question. 
Generally,  however,  the  greater  the  range  in  this  cost 
the  more  varied  will  the  rates  be  and  the  stronger  the 
tendency  to  adjust  the  charge  to  what  it  costs  to  serve 
each  individual.  Then  again,  at  equal  amounts  of 
commodity  furnished  the  nature  of  the  service  may 
vary  greatly,  as  for  example  in  the  case  of  the  delivery 
of  electric  energy  to  operate  motors.  Preparation  must 
be  made  in  such  a  case  to  supply  the  maximum 
amount  of  electric  current  that  may  at  any  time  be 
demanded  by  the  consumer  and  yet  the  consumer  may 
operate  his  plant  at  only  a  small  fraction  of  its  in- 
stalled capacity.  In  such  event  a  charge  is  made  for 
being  ready  to  serve.  The  preparation  to  serve  is  an 
element  of  cost  and  expense  to  the  utility  which. 


136  PUBLIC     UTILITY     RATE     FIXING 

because  it  is  independent  of  the  amount  of  service, 
tends  to  make  the  unit  cost  of  the  service  to  individual 
consumers  unequal. 

Such  items  as  reading  meters,  billing  and  collect- 
ing do  not  change  materially  with  the  amount  of  serv- 
ice called  for  by  the  individual  consumer.  Because 
they  are  relatively  large  in  the  case  of  the  small  con- 
sumer they  add  materially  to  the  cost  of  serving  him. 
They  add  but  little,  on  the  other  hand,  to  the  unit 
cost  of  service  in  the  case  of  the  large  consumer.  It  is 
natural,  therefore,  to  find  the  unit  price  at  which  the 
small  consumer  pays  for  what  he  gets  much  higher 
than  that  at  which  the  large  consumer  is  served. 

Some  Problems  for  Consideration 

The  universal  willingness  of  the  rate  payers  to 
pay  for  what  they  get  and  the  recognition  of  such 
facts  as  these  has  reconciled  the  small  consumer  to.  the 
larger  proportional  payment  which  he  makes.  Fur- 
thermore, because  he  is  a  small  consumer  the  amount 
involved  in  each  monthly  payment  is  small  and  there 
is  no  complaint.  All  the  more  reason,  therefore,  why 
the  rate  fixing  authorities  should  guard  the  small  con- 
sumer against  any  inequitable  distribution  of  the 
charges  for  service  rendered. 

It  is  not  proposed  to  enter  into  a  minute  exposi- 
tion of  the  principles  which  should  control  in  fixing 
the  rates  for  each  type  of  public  service.  These  are 
only  random  comments  on  problems  which  have 
already  provoked  much  discussion.  Thus  for  example, 
certain  water  works  managements  are  endeavoring  to 
secure  application  of  the  principle  that  they  should 
be  compensated  for  being  ready  to  serve  as  in  the  case 
of  the  unoccupied  house  which  is  connected  with  their 
mains  but  is  using  no  water.  The  question  is  how 
far  to  carry  the  ready-to-serve  idea.  Readiness  to 
serve  may  have  considerable  relative  value  as  is  true 
of  the  telephone  or  of  the  installation  necessary  to 
supply  electric  energy  to  a  fire  pump.  Again  it  may 
mean  very  little,  as  in  the  case  of  the  gas  or  water 
main  which  has  a  capacity  to  serve  the  prospective 


THE     RATE     SCHEDULE  137 

consumers  during  the  next  quarter  of  a  century. 
Another  problem  relates  to  the  distribution  of  the 
aggregate  amount  to  be  collected  from  rate  payers  to 
classes  or  groups  into  which  they  can  be  divided  on 
the  basis  of  the  aggregate  costs  of  rendering  the  serv- 
ice to  the  consumers  in  each  group. 

How,  for  example,  shall  the  charges  for  upkeep 
and  operation,  including  interest  on  the  invested  cap- 
ital, be  allocated  in  the  case  of  an  irrigation  system 
which,  by  gravity  flow,  covers  certain  lands  located 
near  the  source  of  supply,  other  lands  remote  from 
this  source  and  also  serves  others  to  which  water  is 
pumped?  Let  it  be  supposed  that  the  situation  is 
such  that  cooperation  of  all  of  the  several  sub-sections 
of  the  area  served  by  the  system  is  essential  to  make 
the  project  economically  feasible.  If,  in  these  circum- 
stances it  is  proper  to  restrict  the  burden  on  each  of 
the  subdivisions  as  here  named  to  an  interest  in  only 
that  part  of  the  system  which  is  essential  to  secure 
to  it  a  delivery  of  water,  then  why  should  not  the 
same  principle  apply  to  each  separate  tract  in  each  of 
the  several  subdivisions?  This  seems  plausible  and 
has  in  one  or  two  cases  been  tried,  as  for  example 
on  one  of  the  older  canals  diverting  water  from  Tule 
river  in  California.  The  land  owners,  in  this  case,  con- 
structed the  canal  as  a  mutual  enterprise,  agreeing 
among  themselves  that  only  the  construction  cost  and 
operating  expenses  down  to  the  point  where  the  main 
canal  reaches  the  lands  of  the  respective  participants, 
should  come  into  consideration  in  estimating  the 
charges  to  be  placed  against  each.  They  overlooked 
the  fact,  and  this  fact  is  generally  overlooked,  that  the 
construction  of  the  canal  added  value  to  their  holdings. 
Let  it  be  supposed  that  this  increase  of  value  was  the 
same  acre  for  acre  near  the  head  of  the  canal  as  at  its 
lower  end.  If  this  increase,  for  purposes  of  illustration, 
be  placed  at  $100  per  acre  and  the  cost  of  the  canal 
was  $20  per  acre  for  the  land  owner  nearest  the  head 
of  the  canal  and  $60  for  the  one  at  its  lower  end,  then 
the  unearned  increment  realized  by  the  former  was 
$80  as  against  only  $40  by  the  latter.  The  apportion- 


138  PUBLIC     UTILITY    RATE    FIXING 

ment  of  construction  cost  on  this  basis  was  not  as  fair 
as  it  appeared  to  be.  Operating  expenses,  in  such  cir- 
cumstances, can,  with  much  greater  propriety,  be  ad- 
justed according  to  the  location  of  the  land  served 
with  water,  thereby  giving  to  each  tract  the  advan- 
tages to  which  its  location  and  other  natural  condi- 
tions may  entitle  it.  In  practice,  however,  it  is  gener- 
ally found  advisable  to  make  no  such  distinction  unless 
peculiar  circumstances  make  the  same  desirable  as 
would  be  the  case  if  from  an  irrigation  system,  orig- 
inally constructed  as  a  gravity  system,  water  were 
pumped  to  higher  lands.  These  lands  being  less  favor- 
ably circumstanced  than  those  covered  by  the  gravity 
system  should,  in  equity  bear  the  additional  burden 
resulting  from  the  installation  and  operation  of  the 
pumps. 

The  Unearned  Increment  as  a  Factor 
That  the  construction  of  an  irrigation  system  may 
add  materially  to  the  value  of  the  land  to  which  it 
supplies  water  is  obvious  and  frequently  this  incre- 
ment of  value  is  at  once  apparent.  The  unearned 
increment  of  value  which  results  from  the  installation 
of  a  telegraph  or  telephone  system,  or  the  establish- 
ment of  an  express  service,  or  from  the  construction 
of  a  street  car  line  or  a  gas  or  water  works  is  often 
uncertain,  not  easily  recognized  and  usually  impossible 
to  express  in  definite  figures.  Furthermore,  the  pros- 
pective realization  of  the  advantages  which  will  result 
from  the  establishment  of  public  utilities  is  frequently 
the  cause  of  high  market  value  of  real  estate.  It  is 
hardly  necessary  to  say  that  the  inflation  of  these 
values  in  anticipation  of  future  improvements  is  some- 
times not  warranted  by  the  circumstances.  The  fact 
remains,  however,  that  the  readiness  and  even  the 
prospective  readiness  of  each  type  of  utility  to  serve 
any  community  does  add  some  increment  of  value  to 
the  property  in  that  community.  The  establishment  of 
each  utility  adds  to  the  general  prosperity.  The  readi- 
ness to  serve,  considered  in  its  broadest  sense  in  other 
words,  affects  the  entire  community  even  as  the  water 
and  the  gas  main  on  any  particular  street  affects  prop- 


THE     RATE     SCHEDULE  139 

erty  values  on  that  street,  and  as  more  obviously  any 
expense  incurred  to  serve  a  particular  tract  of  land 
with  any  necessary  service  or  commodity  adds  value 
to  that  tract. 

Determining  Factors 

In  fixing  the  rates  at  which  the  individual  con- 
sumer is  to  be  charged  for  a  commodity  furnished  by 
a  public  utility  or  for  a  service  rendered,  there  must 
of  course  first  be  a  determination  of  the  aggregate 
amount  to  be  realized  from  an  application  of  these 
rates.  In  fixing  the  items  of  the  rate  schedule  consid- 
eration must  therefore  be  given : 

1st.  To  all  the  factors  affecting  net  earnings  as  here- 
tofore discussed  in  these  articles  with  a  view  to 
determining  the  aggregate  amount  of  gross  earn- 
ings. 

2nd.  To  the  contribution  if  any  which  the  community 
as  a  whole'should  make  to  the  earnings  as  a  return 
of  part  of  the  unearned  increment  in  which  all 
property  owners  participate. 

3rd.  To  the  cost  of  operation  (including  interest  on 
investment)  in  so  far  as  the  same  inures  to  the 
benefit  of  all  consumers. 

4th.  To  that  part  of  the  cost  of  operation  which  is 
incurred  for  the  particular  advantage  of  an  indi- 
vidual consumer  or  a  limited  group  of  consumers. 

These  propositions  do  not  need  special  discussion. 
They  must  be  considered  somewhat  flexible  because 
no  hard  and  fast  rule  can  be  laid  down  where  it  is 
necessary,  as  in  rate  fixing,  to  adopt  a  program  which 
is  based  on  meeting  the  average  requirements  and 
being  fair  to  large  numbers  of  consumers. 

The  Remission  of  Taxes 

In  the  case  of  express  companies,  telegraph  and 
telephone  companies,  the  amount  of  benefit  which 
they  confer  on  the  community  at  large  in  the  shape  of 
an  increase  of  property  value  is  obscure.  But  this 
benefit  is  real  and  should  be  recognized  and  conceded 
to  be  the  result,  in  part  at  least,  of  the  operation  of 
these  public  utilities.  When  compared  with  similar 
or  other  public  utilities  which  are  municipally  owned, 
and  which  pay  no  taxes,  the  question  may  well  be 
asked  —  Why  would  it  not  be  proper  to  waive  taxes 


140  PUBLIC     UTILITY     RATE     FIXING 

on  every  public  utility  throughout  the  district  which 
gets  the  benefit  of  its  service?  If  this  is  done  for  one 
utility  it  should  be  done  for  all.  The  taxpayer  who 
profits  by  an  unearned  increment  would  thus  contrib- 
ute to  the  utility's  earnings  indirectly  (by  the  reduc- 
tion of  operating  expenses)  an  amount  which  would 
be  saved  to  the  rate  payers,  who  are  the  owners  of 
only  a  part  of  the  property  which  benefits  by  increased 
values. 

Ordinarily  little  or  no  consideration  is  given  to 
the  fact  as  here  set  forth  that  every  public  utility, 
theoretically  at  least,  contributes  to  the  unearned  in- 
crement of  every  property  holder  in  the  community. 
The  remission  of  taxes  would  be  a  logical  procedure 
based  on  economically  sound  principles.  Or,  in  case 
of  water  works  and  gas  works,  it  would  be  legitimate 
to  pay  liberally  for  water  and  gas  used  for  public  pur- 
poses, thereby  returning  in  whole  or  in  part  what  has 
been  paid  in  taxes.  It  is  unfair  to  the  rate  payers,  on 
the  other  hand,  to  accept  free  of  charge,  telephone  or 
other  service  whereby  the  burden  of  the  individual 
rate  payer  is  increased  to  the  advantage  of  the  tax 
payer. 

But  it  will  be  said,  in  reply  to  any  contention  for 
a  modification  of  the  common  practice  in  this  partic- 
ular, that,  if  carried  to  its  logical  conclusion,  the  public 
should  not  accept  a  share  of  the  earnings  of  a  privately 
owned  public  utility,  as  is  sometimes  done,  because 
the  larger  earnings  thereby  rendered  necessary  would 
be  unfair  to  the  rate  payer,  and  on  the  same  theory  the 
public  utility  publicly  owned  should  be  operated  at 
a  loss  in  order  that  by  making  up  the  loss  the  general 
public  will  make  an  adequate  contribution  to  operating 
cost.  Such  a  condition  would  not  ordinarily  be  ac- 
cepted as  desirable  because  of  the  ease  with  which  the 
indirect  tax  in  the  gas  and  water  rates,  and  in  the 
street  car  fare  can  be  collected,  however  unfair  and 
inequitable  such  a  tax  may  be. 

While  some  stress  has  been  laid  in  the  above  to 
the  increment  which  the  whole  community  should 
contribute  to  the  earnings  of  the  public  utility  it  must 


THE     RATE     SCHEDULE  141 

be  admitted  that  the  alternative  of  putting  the  load  on 
the  rate  payer  to  lessen  general  taxation  is  tempting 
and  will  be  difficult  to  resist,  particularly  in  these  days 
of  stress  in  which  taxation  in  all  possible  directions  is 
being  increased  by  leaps  and  bounds.  When  thus 
done,  as  when  California  transferred  the  general  taxes 
for  maintenance  of  the  state  government  to  the  public 
utility  rate  payers,  the  collection  is  so  distributed 
throughout  the  year  and  is  so  small  in  the  rate  payers' 
frequent  individual  contribution  that  it  escapes  notice 
and  comment.  None  the  less  it  is  not  equitable  and 
may  in  time  come  to  be  recognized  as  unwise.  It  is 
akin  to  the  practice,  so  often  resorted  to  by  the  busi- 
ness man  and  manufacturer,  of  distributing  overhead 
expenses  unequally  to  their  output,  so  as  to  make  or 
hold  a  market  for  products  that  would  not  sell  if 
charged  with  overhead  at  the  full  quota  determined 
by  a  consideration  of  net  cost  only. 

Rates  for  Electric  Energy 

More  attention  has  probably  been  given  to  an 
adjustment  of  the  rate  schedule  to  the  cost  of  the 
service  in  the  case  of  supplying  electric  energy  than 
in  the  case  of  rendering  any  other  public  service.  There 
is  good  reason  for  this,  because  the  demand  of  individ- 
ual consumers  has  an  exceptionally  wide  range  and  the 
consumers  are  often  isolated  and  scattered  throughout 
a  large  territory.  The  preparation  to  serve  must 
be  adjusted  to  the  demand  of  each  large  consumer 
and  to  the  group  and  frequently  individual  demands  of 
the  smaller  consumers.  In  the  transmission  of  energy 
by  electricity  perhaps  more  than  in  rendering  any 
other  public  service  the  broad  principle  can  be  applied 
as  indicated  by  the  Wisconsin  Railroad  ommission 
that  the1  rates  for  electric  current  should  be  based  on 
the  cost  of  the  service.  The  electric  power  concern 
adjust-;  its  installation  as  stated  to  a  close  conformity 
with  the  requirements  of  individual  consumers.  This 
is  not  nearly  so  essential  in  the  case  of  a  water  works 
which  makes  its  installation  to  meet  the  possible 
future  demand  throughout  the  length  of  a  street  or 


142  PUBLIC     UTILITY     RATE     FIXING 

throughout  an  urban  section  generally  at  a  capacity 
far  in  excess  of  the  immediate  demand,  and  which  com- 
mands with  each  size  of  service  connection  a  wide 
range  of  demand.  In  the  one  case  ready-to-serve 
means  more  to  the  individual  consumer  than  in  the 
other. 

The  electric  power  concern  must  make  its  plant 
and  transmission  lines  and  the  installation  to  serve 
the  individual  consumer,  adequate  to  meet  the  collec- 
tive and  individual  requirements.  Where  the  max- 
imum demand  may  at  some  time  reach  500  horsepower 
the  preparation  to  serve  must  be  for  the  amount  of 
energy.  It  makes  no  difference  that  the  average  de- 
mand may  be  for  only  one-fourth  of  this  amount.  The 
line  and  transformer  installation  must  be  adequate  to 
supply  the  maximum  amount  of  energy  that  may  be 
called  for  and  the  main  line  must  be  such  that  the 
service  can  be  rendered  at  the  same  time  that  other 
consumers  are  calling  for  their  allowed  limit.  The 
charge  must  be  adjusted  to  this  condition  and  the  unit 
charge  if  applied  only  to  the  delivered  energy  would 
appear  higher  under  such  a  condition  than  for  another 
consumer  whose  average  demand  closely  approaches 
the  capacity  of  his  motor  installation.  There  is,  there- 
fore, when  rates  are  to  be  fixed  a  determination  to  be 
made  of  the  cost  of  being  prepared  to  serve  and  of  the 
cost  of  supplying  the  energy.  The  costs  thus  deter- 
mined will  then  be  the  guide  to  the  charges  which 
should  be  made  to  make  the  business  profitable.  In 
line  with  this  reasoning  the  operating  expenses,  with 
inclusion  of  interest  on  the  investment,  naturally  fall 
into  two  classes  of  which  the  one  class  will  include 
only  such  expenses  as  are  independent  of  the  energy 
output  and  the  other  will  include  those  which  vary 
with  the  output  of  energy.  The  basis  of  the  charge  to 
the  consumer  will  then  be  the  sum  of  these  distributed 
costs  with  profit  added.  Consideration  of  the  stable 
or  demand  cost  items,  in  distinction  from  the  variable 
or  energy  cost  items,  naturally  teads  to  the  fixing  of 
a  minimum  charge  which  ordinarily  will  also  cover  the 
cost  of  meter  reading,  billing  and  collecting. 


THE     RATE     SCHEDULE  143 

Gas  and  Water  Rates 

The  consumer  is  generally  required  to  pay  for 
the  service  connection  with  gas  and  water  mains.  Gas 
and  water  meters  are  furnished  to  him  without  charge. 
So  long  as  gas  and  water  are  not  turned  off  from  any 
premises  the  meters  are  read,  bills  are  made  out  and 
charges  are  collected.  There  is  here,  therefore,  a  serv- 
ice rendered  independent  of  the  amount  of  gas  and 
water  consumed  for  which  some  charge  is  legitimate. 
When,  however,  premises  are  vacated  and  the  gas  and 
water  are  turned  off  the  premises  are  restored  almost 
to  the  condition  of  the  unimproved  lot.  The  only  dif- 
ference is  the  presence  of  a  service  connection  and  a 
gas  and  possibly  a  water  meter  which  are  subject  to 
a  charge  for  future  replacement  (depreciation)  and  to 
an  interest  charge  on  the  capital  invested  by  the  util- 
ity, if  there  be  any,  in  the  connection  and  the  meter. 
These  elements  of  cost  are  often  too  small  to  deserve 
serious  consideration  as  the  sole  basis  for  a  rate,  par- 
ticularly when  such  a  rate  is  to  be  assessed  against 
vacant  premises  and  would  therefore  fall  into  a  time 
when  the  owner's  income  is  less  than  ordinary  and  he 
is  least  able  to  pay.  Ordinarily  there  will  be  so 
little  difference  between  the  lot  with  a  vacant  house 
and  an  unimproved  lot  that  if  there  is  to  be  a  ready- 
to-serve  charge  in  the  one  case  the  question  may  well 
be  asked — why  not  in  the  other:'  If  anything  apart 
from  raising  rates  is  necessary  to  swell  earnings 
should  it  not,  as  alreadv  suggested,  take  the  form  of 
a  waiver  of  taxes  or  an  increased  payment  for  water 
used  for  public  purposes? 

In  the  distribution  of  the  aggregate  amount  to  be 
earned  there  will  always  be  some  comprehensive  or 
class  treatment  necessary  which  can  not  be  made 
absolutely  fair  to  each  individual  rate  payer  and  prop- 
erty owner,  lie  who  lives  on  the  hill  top  may  not  at 
all  times  get  his  water  under  as  great  a  pressure  as 
his  neighbor  at  the  foot  of  the  hill.  Or,  again,  no 
di (Terence  will  be  found  in  the  rates  applied  to  prop- 
erty owners  in  some  district  which  is  at  so  high  an 
elevation  that  water  must  be  pumped,  and  the  rates 


144  PUBLIC     UTILITY     RATE     FIXING 

applied  to  those  whose  needs  can  be  met  by  gravity 
flow.  In  such  circumstances  the  ordinary  practice  is 
to  treat  the  entire  municipality  as  a  unit  and  to  regard 
the  service  rendered  as  no  more  valuable  to  the  hill  top 
resident  than  to  the  one  who  lives  at  a  lower  elevation. 
This  is  a  wise  rule ;  though  there  are  cases  in  which  it 
has  not  been  followed,  in  which  there  is  an  additional 
local  charge  based  on  pumpage  or  other  similar  ex- 
penses. 

That  the  unit  cost  of  any  commodity  or  of  service 
obtained  from  a  public  utility  should  be  greater  to  the 
small  consumer  than  to  the  large  consumer  will  ordi- 
narily be  accepted  as  reasonable.  But  an  accentuation 
of  this  disparity  by  easing  up  on  the  large  consumer 
as  his  consumption  increases,  is  often  unwarranted. 

By  reference  to  almost  any  schedule  of  water  rates 
it  will  be  found  that  the  charge  for  furnishing  the 
water  decreases  as  the  amount  increases.  This  ar- 
rangement of  the  schedule  except  as  necessary  to 
cover  the  expenses  of  meter  reading,  billing  and  col- 
lecting and  the  like  is  not  always  as  unfair  to  the  small 
consumer  as  a  mere  comparison  of  the  unit  rates  may 
indicate.  If  the  large  consumer  is  conducting  an 
enterprise  which  is  worthy  and  needs  help  from  the 
community,  it  may  well  be  claimed  that  aid  should  be 
extended  in  some  way  that  will  insure  a  contribution 
from  all  property  owners  and  not  under  cover  of  an 
inequitable  water  or  gas  rate.  After  provision  is  made 
to  obtain  from  each  consumer  the  special  charge 
against  his  individual  service,  why  should  not,  in  other 
words,  the  unit  rate  for  gas  and  water  be  uniform  to 
large  and  small  consumers  alike?  The  answer  is  that 
it  should  be,  whenever  the  demand  for  the  service  or 
output  of  the  utility  is  at  the  limit  of  or  exceeds  the 
plant  capacity;  but  that  when  this  is  not  the  case  it 
may  be  to  the  advantage  of  the  small  as  well  as  the 
large  consumer  to  encourage  large  scale  consumption 
even  though  at  less  than  average  rates  because  revenue 
is  thereby  increased  without  materially  affecting  the 
aggregate  cost  of  operation.  It  will  not  do,  therefore, 
to  condemn  offhand  a  rate  schedule  because  it  seems 


•;  1 1 1  <f.slis1«fl 


THE     RATE     SCHEDULE  145 

to  favor  the  large  consumer.  All  the  circumstances  of 
the  case  must  be  considered  before  a  satisfactory  con- 
clusion can  be  reached. 

Street  Car  Fare 

The  rate  schedule  of  a  street  car  system  appears 
to  be  of  the  utmost  simplicity.  Nevertheless  the  ad- 
justment of  the  service  to  the  single  fare  in  a  primary 
zone  offers  peculiar  problems.  The  points  at  which 
a  car  will  be  stopped  to  take  on  passengers  are  some- 
times close  together;  the  stop  may  be  made  to  let  a 
single  passenger  get  on  or  off  the  car;  the  passenger 
may  be  one  of  many  on  the  car  or  he  may  be  the  sole 
passenger;  he  may  be  riding  a  short  or  a  long  distance, 
up  hill,  or  down  hill,  or  along  a  level  stretch  of  track ; 
he  may  find  the  car  ready  at  hand  when  he  desires  to 
get  on  board  or  he  may  have  to  wait  a  considerable 
time  before  the  car  arrives  at  the  point  wrhere  he  is 
waiting  for  it.  When,  therefore,  he  pays  the  average 
price  for  the  service  immediately  desired  he  may  be 
getting  very  much  more  or  very  much  less  than  an 
average  amount  of  service.  If  he  lives  close  to  his  place 
of  business  and  yet  uses  the  car  in  going  to  and  from 
the  same  he  may  be  habitually  paying  many  times 
more  for  his  transportation  than  others  who  live  far 
away  from  the  business  section. 

The  relation  which  exists  between  the  single  fare 
and  the  average  cost  of  furnishing  transportation  is 
lost  when  the  single  fare  is  compared  with  the  cost  of 
rendering  the  individual  service. 

If  a  car  line  which  is  under  consideration  ex- 
changes transfers  with  another  line  account  must  be 
taken  in  the  cost  analysis,  of  those  passengers  whose 
fare  must  be  divided  with  the  other  line.  The  average 
receipts  per  passenger  carried  may  be  materially  less 
than  the  single  fare  for  this  reason.  So,  too,  the  free 
passes  given  to  employes  and  municipal  officials,  as 
also  the  special  rates  to  school  children  and  sometimes 
to  workingmen  will  reduce  the  average  receipt  per 
passenger.  Such  circumstances  are  to  be  taken  into 
account  in  any  analvsis  of  the  net  return,  in  the  deter- 


146  PUBLIC     UTILITY    RATE     FIXING 

mination  of  zone  limits  or  in  fixing  the  amount  of  the 
single  fare. 

The  Zone  System 

The  single  fare  is  generally  made  uniform  to  sim- 
plify collection  thereof  and  is  made  applicable  to  zones 
of  greater  or  less  extent,  a  single  primary  zone  fre- 
quently embracing  an  entire  city. 

The  custom  is  almost  universal  in  our  own  coun- 
try to  adopt  the  smallest  convenient  coin,  the  nickel 
(5  cents)  as  the  minimum  and  standard  fare  in  the 
primary  zone.  This  has  sometimes  resulted  in  giving 
the  operating  company  a  return  which  is  large  in  com- 
parison with  the  cost  of  rendering  the  service.  Earn- 
ings have  been  in  excess  of  a  reasonable  return — a  con- 
dition not  always  regarded  with  favor  by  the  public. 
To  correct  this  situation  many  cities  have  adopted  a 
plan  of  profit  sharing  or  rather  a  plan  under  which 
the  community  which  is  being  served  gets  a  part  of  the 
gross  earnings.  It  has  been  found  that  when  the  pros- 
pective profits  are  large  the  franchise  has  a  market 
value  and  can  be  sold  and  that  the  proponents  of  the 
street  car  line  are  generally  willing  not  alone  to  pay 
something  for  a  franchise  but  also  to  obligate  them- 
selves to  make  additional  future  payments  based  on 
the  gross  receipts. 

Where  the  primary  zone  is  relatively  small  or  the 
number  of  fares  per  mile  of  track  is  relatively  high  it 
has  in  some  cities  been  found  desirable  to  afford  oppor- 
tunity to  get  the  service  at  less  than  the  standard  5 
cent  rate.  This  is  accomplished  by  using  tickets  which 
can  be  obtained  for  less  than  the  cost  of  a  single  fare. 
Thus  for  example,  at  Washington,  D.  C,  six  tick- 
ets can  be  obtained  for  25  cents.  When  it  becomes 
necessary  (as  must  be  expected  in  time  because  the 
value  of  money  is  declining)  to  increase  the  return  of 
street  car  lines,  the  question  will  be  whether  to  raise 
the  fare  or  to  restrict  the  primary  and  other  zones 
throughout  which  the  fare  is  uniform.  Whenever 
either  is  attempted  there  will  be  protest  and  the  entire 
question  of  adequacy  of  the  rate  in  the  light  of  all  the 


THE     RATE     SCHEDULE  147 

elements  that  affect  the  question  of  net  earnings  will 
have  to  be  brought  under  review. 

Essentials  in  Street  Car  Operation 

In  the  case  of  the  street  car  line,  perhaps  more 
than  in  the  case  of  any  other  public  utility,  an  analy- 
sis of  all  the  factors  which  affect  cost  of  operation  and 
receipts,  present  and  prospective,  is  essential.  It  will 
not  do  to  operate  too  many  cars,  nor  yet  to  inconven- 
ience the  public  by  operating  too  few.  Extensions 
into  new  territory  must  be  made  at  the  right  time. 
If  made  too  soon  the  region  served  may  be  long  in 
growing  up  to  a  paying  basis,  if  delayed  too  long  com- 
petition is  invited.  The  general  and  local  growth  of 
the  community  must  be  studied  in  order  that  the 
service  rendered  may  keep  pace  with  the  demand. 
The  fullest  attention  to  these  matters  is  essential  in 
order  that  the  good  will  of  the  public  may  be  retained 
and  so  far  as  practicable  competing  lines  will  be  kept 
out  of  the  territory  commanded  by  the  system.  It 
goes  without  saying  that  in  the  transportation  service, 
as  in  the  case  of  other  public  utilities  as  is  notably 
true  of  the  telephone,  there  should  be  no  competition. 
The  best  service  can  be  rendered  under  unified  man- 
agement provided  always  that  the  service  is  under 
proper  and  wise  regulation. 

The  Railroad  Rate  Schedule 

The  same  fundamental  principles  should  apply  in 
the  fixing  of  a  rate  schedule  for  the  transportation  of 
passengers  and  freight  over  a  railroad  as  apply  to  other 
utilities.  But  owing  to  the  fact  that  the  railroad  may 
come  into  competition  with  water  transportation  there 
has  been  a  glaring  departure  from  these  principles  in 
one  respect  which  deserves  notice.  The  unequal  dis- 
tribution of  overhead  has  been  carried  to  the  extreme. 
This  is  particularly  noticeable  in  the  resulting  low 
through  rates  when  compared  with  local  rates.  It  is 
noticeable,  too,  whenever  the  railroad  freight  rates 
along  a  navigable  river  or  canal  are  compared  with 
the  rates  for  similar  service  into  regions  where  there 
is  no  competition.  This  is  the  natural  outcome  of  the 


148  PUBLIC    UTILITY    RATE    FIXING 

desire  of  the  railroad  companies  to  charge  "all  the 
traffic  will  bear."  Under  regulation  there  is  now  a 
tendency  away  from  this  policy  and  the  time  is  ap- 
proaching when  we  may  hope  to  see  a  fair  uniformity 
in  the  charge  for  service  wherever  rendered.  Unifica- 
tion of  the  railroad  systems  of  the  country  and  their 
operation  under  one  management,  so  that  the  lack  of 
business  on  one  line  will  be  offset  by  more  than  aver- 
age business  on  another,  would  be  the  ideal  arrange- 
ment. Adjustment  to  such  a  program  would  probably 
not  be  as  difficult  as  it  might  at  first  appear  to  be, 
although  there  would  necessarily  be  a  transition  period 
that  would  bear  heavily  here  and  there. 

The  Long  Haul  Question 

It  is  a  well  known  fact  that  the  through  freight 
rates  from  the  Atlantic  to  the  Pacific  Coast  were  fixed 
with  a  view  to  securing  business.  Certain  terminal 
points  wrere  named  to  which  goods  could  be  shipped  at 
rates  less  than  to  intermediate  points.  This  resulted 
in  the  hauling  of  goods  to  points  far  beyond  their  ulti- 
mate destination  and  then  part  way  back,  and  to  a 
charge  which  could  command  this  amount  of  service 
whether  the  full  service  was  actually  rendered  or  not. 
During  the  period  when  the  railroads  fixed  their  tariffs 
at  will  they  acted  upon  the  theory  that  the  low 
through  freight  rates  would  keep  down  water  competi- 
tion and  that  this  would  result  to  their  advantage. 
"Whether  or  not  the  result  met  their  expectations  is 
not  so  much  a  question  of  interest  as  the  broader  ques- 
tion of  whether  they  could  not  in  the  end  have  con- 
ducted an  equally  profitable  business  under  rates 
adjusted  approximately  at  least  to  the  cost  of  the 
service. 

By  the  system  of  low  terminal  rates  the  develop- 
ment of  the  interior  of  the  country  has  been  handi- 
capped. There  are  those  to  whom  it  appears  that  this 
was  not  at  all  essential  to  make  the  railroads  success- 
ful and  that  it  resulted  in  disadvantage  to  the  nation. 
How  much  better  it  would  have  been,  for  example,  to 
have  let  the  bulk  of  the  cross-continent  freight  be 


THE     RATE     SCHEDULE  149 

brought  into  the  Pacific  Coast  ports  by  boat  and  then 
be  distributed  to  interior  points  by  rail  at  local  rates 
than  to  have  the  freight  delivered  directly  at  prac- 
tically the  same  cost  of  transportation  to  its  ultimate 
destination?  There  would  have  been  more  rapid  and 
larger  development  of  the  resources  of  the  country 
and  the  steamship  and  shipping  companies  could  have 
prospered.  The  country  Would  not,  at  the  beginning 
of  the  present  critical  period  of  its  history,  have  found 
itself  without  a  merchant  marine. 

Artificial  Competition  with  Water  Transportation 

To  justify  a  continuance  of  the  unbalanced  rates 
even  under  regulation  by  the  Interstate  Commerce 
Commission,  the  fiction  is  still  maintained  of  treating 
the  distance  to  terminals  which  are  affected  by  water 
competition  as  less  than  they  are  in  fact.  This  is,  how- 
ever, an  unwise  policy  and  will,  it  is  hoped,  be  aban- 
doned at  an  early  day.  It  puts  a  burden  on  the  other 
rate  payer  that  he  should  not  be  asked  to  carry.  Let  the 
service,  where  possible,  be  rendered  by  the  steamboat, 
even  though,  for  a  time,  a  competing  railroad  already 
constructed  does  not  pay.  Under  one  ownership  of  all 
the  railroads  this  would  result  in  no  hardship  provided 
that  the  rate  schedule  throughout  was  properly  re- 
arranged. Needless  to  say  that  in  many  cases  the 
competing  road  should  not  have  been  built  at  all.  That 
its  construction  was  permitted  is  in  some  measure  the 
fault  of  the  public  which  encouraged  the  haphazard 
way  in  which  railroad  building  was  undertaken. 

It  is  not  proposed  to  enter  into  a  full  discussion 
of  certain  other  factors  which  complicate  the  problem 
of  adjusting  railroad  rates  to  the  cost  of  rendering  the 
service.  The  reasonableness  of  the  charge  must  be 
considered,  the  question  of  whether  or  not  rates  should 
be  uniform  within  certain  zones ;  the  vast  increase  of 
cost  that  results  when  the  patronage  is  relatively  light 
as  in  sparsely  settled  regions,  and  the  increase  of  cost 
when  goods  are  carried  in  less  than  carload  lots — all 
these  must  be  weighed  when  the  railroad  freight  and 
passenger  schedules  are  to  be  prepared. 


150  PUBLIC     UTILITY     RATE     FIXING 

Difficulties  in  Rate  Adjustment 

Transportation  involves  responsibility  for  the 
proper  care  and  protection  of  the  persons  and  articles 
which  are  transported.  Consequently  the  railroads, 
and  also  express  companies,  take  cognizance  in  their 
rate  schedules  not  alone  of  weight  but  also  of  bulk, 
character  and  value  of  the  articles  which  are  entrusted 
to  them  for  delivery  at  a  specified  destination.  Fur- 
thermore, as  the  amount  of  care  and,  too,  the  conven- 
ience of  handling  may  be  reduced  materially  by  proper 
boxing  and  crating,  the  rates  are  often  much  lower  for 
the  properly  packed  article  than  for  the  same  article 
unprotected  by  box  or  crate.  And  finally  due  consid- 
eration must  be  given  to  an  adjustment  of  rates  or 
rather  to  the  fixing  of  special,  less  than  average,  rates 
to  meet  the  requirements  of  certain  sections  of  the 
country,  whose  industries  or  occupations  would  not 
otherwise  survive.  Such  circumstances  and  others 
often  of  purely  local  flavor  are  constantly  presented 
and  make  the  solution  of  the  railroad  rate  schedule 
problem  difficult. 

The  Government  Problem 

It  remains  to  be  stated  that  under  government 
ownership  of  the  entire  railroad  system  of  the  country 
the  modification  of  rate  schedules  would  be  a  compara- 
tively simple  matter.  The  loss,  if  any,  wherever  it 
results  under  application  of  reasonable  rates  would  fall 
upon  the  public  and  would  not  necessarily  be  put  on 
those  who,  at  some  subsequent  time,  travel  on  the 
railroad  or  ship  freight. 


THE     PUBLIC     UTILITY     RATE     BASE  151 

CHAPTER  IX 

THE  UTILITY  RATE  BASE 

Value  as  a  Rate-Base  Illogical 

The  writer,  and  also  C.  E.  Grunsky,  Jr.,  in  the  ar- 
ticles of  this  series,  have  endeavored  to  make  it  plain 
that  value  is  not  the  logical  starting  point  when  public 
utility  rates  are  to  be  fixed.  Those  who  have  read  these 
articles  will  realize  that  it  would  be  difficult  to  find 
valid  reasons  for  bringing  the  net  earnings  into  some 
relation  to  value,  other  than  the  decisions  of  the  courts 
which  in  their  endeavor  to  protect  property  against 
confiscation  are  necessarily  concerned  with  value.  The 
question  may  well  be  asked  whether  in  the  last  analy- 
sis value  can  be  ascertained  except  by  capitalization  of 
earnings  and  whether,  after  all,  what  the  courts  are 
called  upon  to  protect,  may  not  be  defined  as  the  in- 
vested capital  plus  the  reward  to  which  the  owners  of 
the  enterprise  are  entitled  for  having  engaged  in  and 
developed  a  necessary  business,  usually  in  advance  of 
the  time  when  the  same  could  or  would  have  been  es- 
tablished by  the  public. 

The  Natural  Rate-Base 

Full  justice  would  be  done  if  the  rate  base,  pre- 
ferably the  invested  capital,  properly  ascertained,  as 
explained  in  earlier  articles  of  this  series,  when  once 
established  would,  thereafter,  remain  unchanged  ex- 
cept as  made  necessary  by  abandonments  and  better- 
ments or  other  new  investments.  Capital  can  thus  be 
left  unimpaired.  This  natural  rate  base  would  be 
unaffected  by  accrued  depreciation.  Value  would  cease 
to  be  an  element  for  consideration  in  determining  the 
rate  base.  But  the  fact  must  not  be  overlooked  that 
the  reward  of  the  owner  for  the  risk  he  has  assumed. 
and  for  management  and  also  the  participation  in  gen- 
eral prosperity  to  which  he  is  entitled  should  appear 


152  PUBLIC     UTILITY     RATE     FIXING 

in  his  net  earnings.  These  elements  should,  perhaps 
in  some  such  amount  as  the  author  has  heretofore 
suggested  be  brought  into  fair  relation  to  the  volume 
of  business. 

Under  such  treatment  of  the  valuation  problem 
in  connection  with  the  establishment  of  rates,  all  of 
the  vexed  questions  brought  up  by  the  varying  treat- 
ment of  appreciating  values  would  be  eliminated.  The 
unearned  increment  would  be  transformed  into  actual 
earnings.  The  trouble,  too,  of  placing  a  value  upon 
the  going  concern  would  fall  away  because  this  would 
take  care  of  itself.  Going  value  together  with  all  other 
intangible  values  would  appear  in  the  capitalization 
of  the  net  earnings. 

Under  such  a  system  of  rate-fixing,  the  rate-fixing 
authority  would  be  concerned  with  replacement  re- 
quirements instead  of  depreciation.  These  would  have 
to  be  approximated  on  the  basis  of  past  experience  and 
would  naturally  be  so  distributed  over  a  series  of 
years,  preferably  in  anticipation  of  the  requirement, 
that  rates  once  established  would  not  have  to  be  mod- 
mea  too  frequently.  It  will  be  immaterial  how  the 
requirement  is  ascertained.  Any  method  of  procedure 
which  will  fairly  approximate  the  desired  result  will 
suffice. 

Restrictions  Imposed  by  Court  Decisions 

In  the  rate  case  of  the  Spring  Valley  Water  Co. 
vs.  City  and  County  of  San  Francisco,  reported  upon 
by  the  Mastery  in  Chancery,  Mr.  H.  M.  Wright  in 
October,  1917,  the  Master  clearly  sets  forth  the  fact 
that,  under  the  prevailing  interpretation  of  the  decis- 
ion of  the  courts,  the  value  of  the  property  that  should 
be  used  as  a  rate  base  is  the  value  which  would  be 
found  in  condemnation  proceedings.  The  property  to 
be  valued  in  the  Spring  Valley  case  includes  about 
100,000  acres  of  watershed  and  reservoir  lands  which 
have  since  their  acquisition  been  increasing  in  value. 
As  will  be  seen  by  reference  to  a  preceding  article  of 
this  series,  this  increase,  if  determined  from  assessor's 
valuations  of  real  estate  in  the  South  San  Francisco 


THE     PUBLIC     UTILITY     RATE     BASE  153 

Bay  region  and  from  population  increase,  is  a  material 
factor.  If  as  held  by  the  courts  all  such  property 
while  in  use  must  be  taken  into  the  rate  base  at  its 
actual  value,  there  will  be  a  constantly  and  perhaps 
rapidly  growing  rate  base  to  be  taken  into  acount  even 
at  times  when  there  are  no  betterments  or  extensions 
involving  additions  to  invested  capital.  The  owner  of 
the  utility  will  get  the  unearned  increment  on  which 
he  can  realize  sooner  or  later  and  although  this  does 
not  represent  actual  additional  investment,  it  must  be 
treated  just  as  new  capital  would  be  treated  and  the 
owner  in  addition  to  benefitting  by  the  extent  of  the 
unearned  increment  will  be  in  a  position  to  realize  a 
return  thereon,  equivalent  to  that  which  would  be  al- 
lowed if  the  appreciation  represented  actual  new  in- 
vestment. 

Appreciation  and  the  Rate-Base 

When  from  the  standpoint  of  the  rate  payer,  it  is 
considered  that  a  liberal  rate  of  return  on  the  actual 
investment  will  protect  the  owner  against  loss,  and 
that  the  unearned  increment  is  the  result  of  a  favor- 
able environment  produced  by  society  and  only  in 
part  by  the  owner  of  the  utility,  and  further  that  those 
utilities  with  but  little  real  estate  or  other  appreciat- 
ing property  deserve  the  same  liberal  treatment  as 
those  who  own  broad  acres,  then  it  becomes  apparent 
that  there  are  additional  sound  reasons  why  value 
should  not  be  treated  as  the  rate  base.  This  proposi- 
tion would  be  recognized  and  would  no  doubt  find 
much  more  general  support  if  the  court  decisions  on 
this  subject  did  not  stand  in  the  way.  Nevertheless, 
where  a  different  procedure  from  that  apparently  laid 
down  by  the  courts  is  logical  and  leads  to  a  simplifi- 
cation of  all  calculations  and  is  fair  to  both  owner  and 
rate  payer,  it  will  always  invite  discussion  and  it  is 
hoped  that  the  time  will  come  when  the  true  signifi- 
cance of  the  simplifications  described  in  these  articles 
will  be  generally  recognized. 

It  will  not  be  out  of  place  here  to  refer  to  the  sit- 
uation with  which  San  Francisco  and  the  Spring  Val- 


154  PUBLIC     UTILITY     RATE     FIXING 

ley  Water  Company  are  now  confronted  in  the  matter 
of  advancing  real  estate  values.  In  the  Master's  re- 
port already  referred  to  Mr.  Allen  Hazen  of  interna- 
tional standing  in  the  engineering  profession,  called 
as  a  witness  for  the  Water  Company,  is  quoted  as  say- 
ing: 

"It  seems  to  me  that  the  value  of  the  lands  in 
the  Peninsula  works  and  the  rights  as  they  have 
been  valued  in  this  case"  (by  experts  for  the  Water 
Company)  "have  reached  the  point  where  the  sys- 
tem as  a  water-works  property  is  valued  for  about 
all  the  market  will  stand.  I  should  say  that  if  the 
lands  for  instance  doubled  in  value  in  view  of  the 
general  situation,  as  a  water-works  property,  the 
price  taken  into  the  rating  base  ought  not  to  go  up 
in  proportion,  that  is,  in  view  of  the  cheaper  water 
from  Alameda  and  the  possibility  of  other  water 
being  brought  into  the  market." 

Here,  as  is  already  true  of  the  ranch  lands  sur- 
rounding Lake  Merced,  a  natural  body  of  water  within 
the  limits  of  San  Francisco  and  still  in  use  as  a  source 
of  supply,  the  question  may  some  day  have  to  be  an- 
swered whether  or  not  the  continued  ownership  of  all 
the  watershed  lands  appearing  at  their  increasing  val- 
ues in  the  rate  base  can  be  afforded,  or  whether  the 
time  has  not  come  as  suggested  by  Mr.  Hazen  when 
there  should  be  no  further  unearned  increment  allowed, 
thereby  creating  a  condition  under  which,  while  per- 
haps getting  some  presumably  reasonable  participation 
in  the  general  prosperity,  the  unearned  increment 
would  no  longer  be  added  to  the  rate  base  and  could 
not  be  realized  upon,  until  the  property  in  question 
is  released  from  public  service. 

Under  the  ordinary  procedure  in  rate  fixing,  when 
value  controls,  the  owner  will  claim  and  should  be 
allowed  the  unearned  increment  and  a  return  thereon. 
Under  the  alternative,  that  is,  under  protection  of  in- 
vestment and  the  use  of  what  the  author  calls  the 
natural  rate  base,  he  will  get  a  share  in  the  general 
prosperity  which  may  be  greater  or  less  than  the  un- 
earned increment,  and  he  will  in  the  case  of  property 
released  from  service  also  obtain  the  appreciation.  In 
this  alternative  case  the  degree  of  participation  in  gen- 
eral prosperity  should,  as  heretofore  explained,  be 


THE     PUBLIC     UTILITY    RATE     BASE  155 

based  rather  on  volume  of  business  than  on  the  cap- 
ital invested. 

In  regard  to  the  Spring  Valley  Water  Company's 
property  on  the  San  Francisco  peninsula,  Mr.  Hazen 
would  apparently  prefer  that  hereafter  some  such  pro- 
cedure as  outlined  in  the  alternative  should  be  adopted. 
He  would,  if  correctly  understood,  have  these  land 
values,  as  now  determined  (on  the  basis  of  their  pres- 
ent value)  appear  without  further  increase  in  any  rate 
base  hereafter  determined.  Perhaps  he  is  right.  He 
is  apparently  beginning  to  accept  the  writer's  view 
that  rate  base  and  value  are  not  synonymous. 

The  further  discussion  of  value  and  the  rate  base 
in  relation  to  each  other  will  be  found  in  the  article 
of  this  series  by  C.  E.  Grunsky,  Jr.,  entitled  "Fair 
Value  and  the  Rate  Base." 


156  PUBLIC     UTILITY    RATE     FIXING 

CHAPTER  X 
FAIR  VALUE  AND  THE  RATE  BASE 

By 
C.  E.  GRUNSKY,  JR.,  E.  M.,  CAPT.  U.   S.  N.  A. 

Special  Committee  of  Am.  Soc.  C.  E.  on  "Fair  Value" 
and  "Fair  Return" 

The  extremely  important  subject  of  the  proper 
basis  for  the  determination  of  the  rates  of  public  utili- 
ties has  been  ignored  in  the  final  report  of  the  special 
committee  to  formulate  principles  and  methods  for  the 
valuation  of  railroad  property  and  other  public  utili- 
ties in  the  proceedings  of  the  American  Society  of 
Civil  Engineers,  December,  1916.  This  report  states: 

"That  whether  or  not  it  is  proper  to  base  rates  on  the 
so-called  'value'  of  the  property  is  no  concern  of  the  com- 
mittee. The  fact  is  that  in  many  instances,  including  cases 
of  railroad  rates,  the  reasonableness  of  rates  has  been  so 
determined,  and  in  making  their  decisions  in  disputed  cases, 
the  courts  have  quite  uniformly  held  that  a  public  utility 
corporation  is  entitled  to  earn  a  'fair'  return  on  the  'fair 
value'  of  its  property  used  in  the  public  service." 

In  reading  carefully  the  report  of  this  committee, 
it  will  be  noted  that,  true  to  this  statement,  considera- 
tion has  not  been  given  to  the  determination  of  the 
proper  basis  for  rate-fixing. 

Functions  of  Rate  Fixing  Authorities  and  of  Courts 
Not  the  Same 

To  discuss  at  length  here  the  report  of  this  com- 
mittee is  not  practicable,  but  it  seems  desirable  to 
point  out  that  the  court  cases  quoted  by  the  committee 
and  by  the  authors  of  works  on  valuation  are  cases 
which  review  the  proceedings  of  lower  courts  and 
which  were  instituted  to  decide  the  reasonableness  of 
rates  which  already  had  been  determined  by  commis- 
sions or  other  rate-fixing  bodies.  Although  these  cases 


FAIR     VALUE     AND     THE     RATE     BASE        157 

fix  with  some  definiteness  the  measure  which  shall  be 
applied  to  determine  the  propriety  of  these  rates,  they 
do  not  restrict  the  rate-fixing  body  to  any  definite 
method  of  determining  the  proper  rates.  They  do 
state,  however,  that  the  "fair  value"  shall  be  the  basis 
of  the  calculation  for  determining  whether  these  rates 
allow  a  return,  fair  to  the  rate-payer  and  fair  to  the 
utility.  The  fixing  of  rates  is  purely  a  legislative 
function  and  it  cannot  be  exercised  by  the  courts. 

The  case  of  Smyth  vs.  Ames1  is  a  leading  case  in 
which  the  Supreme  Court  has  set  forth  its  view  of  the 
proper  procedure  in  determining  the  reasonableness 
of  rates.  These  views  are  in  part  as  follows : 

"The  basis  of  all  calculations  as  to  the  reasonableness 
of  rates  to  be  charged  by  a  corporation  maintaining  a 
public  highway  under  legislative  sanction  must  be  the  fair 
value  of  the,  property  being  used  by  it  for  the  convenience 
of  the  public." 

The  court  in  this  case  further  states: 
"And  in  order  to  ascertain  the  original  cost  of  construc- 
tion, the  amount  expended  in  permanent  improvements,  the 
amount  and  market  value  of  its  bonds  and  stock,  the  present 
as  compared  with  the  original  cost  of  construction,  the  prob- 
able earning  capacity  of  the  property  under  the  particular 
rates  prescribed  by  statute  and  the  sum  required  to  meet 
operating  expenses,  are  all  matters  for  consideration  and 
are  to  be  given  such  weight  as  may  be  just  and  right  in  each 
case." 

This  decision  has  been  cited  frequently  since  the 
date  of  its  submission  and  the  conclusion  quite  gen- 
erally drawn  that  the  method  of  fixing  rates  has  been 
forever  settled. 

However,  let  us  consider  whether  this  is  the  case. 
The  purpose  of  the  court  was  one  of  review,  to  deter- 
mine if  confiscation  had  taken  place  or  if  the  rates 
would  create  a  value  unreasonably  high.  In  other 
words,  it  was  necessary  to  determine  value  and  the 
court  says  this  is  the  "fair  value"  taking  into  account 
among  other  elements  of  value,  the  probable  earning 
capacity  of  the  property  under  the  particular  rates 

M169   U.    S.    466,    1898). 


158  PUBLIC     UTILITY     RATE     FIXING 

prescribed  by  statute  and  the  sum  required  to  meet 
operating  expenses.  It  is  self  evident  that  the  phys- 
ical properties  when  considered  separately  have  value 
for  other  purposes,  but  this  is  not  the  value  which 
the  court  demands,  the  value  of  the  entire  property 
as  an  operating  utility.  Value  properly  determined, 
taking  into  account  all  its  elements,  is  the  result  of 
earnings  and  not  the  cause  thereof.  The  circle  must 
be  avoided.  Rates  cannot  create  value  and  then  value 
be  used  as  a  basis  for  rates. 

The  Use  of  Value  when  Fixing  Rates 
Impracticable 

To  point  out  in  detail  the  difficulties  encountered 
in  attempting  to  justify  the  use  of  "fair"  or  "present" 
value  as  a  basis  for  rate-fixing  is  not  possible  here. 
The  conviction  that  such  a  method  of  rate-fixing  is 
impracticable  becomes  fixed  when  we  note,  in  the  com- 
mittee report  previously  mentioned,  the  segregation 
of  physical  property  into  three  classes  each  requiring 
a  different  method  for  determining  "fair  value,"  the 
various  methods  adopted  for  determining  accrued  de- 
preciation (lessening  of  worth)  and  the  complex  sys- 
tems of  accounting  that  are  involved.  The  determina- 
tion of  "fair"  or  "present"  value  is  rendered  difficult 
by  the  hopelessness  of  attempting  to  determine  the 
depreciated  condition  of  the  plant.  Articles  estimated 
as  having  a  20-year  life  will  insist  on  failing  to  go  out 
of  use  exactly  20  years  from  the  date  of  installation. 
Some  will  go  out  of  use  very  early  in  their  expected 
life  and  thus  unfairly  deprive  the  utility  of  the  annual 
depreciation  on  the  article.  Some  articles  of  20-year 
probable  life  may  live  to  the  age  of  30  or  40  years. 
Shall  these  articles  be  allowed  (assuming  the  straight 
line  method)  l/20th  of  their  value  annually  as  depre- 
ciation during  the  full  30  or  40  year  period?  Account- 
ants have  adopted  methods  to  take  care  of  this 
depreciation,  but  as  these  methods  involve  either 
depreciation  payments  in  advance  before  the  failure 
has  occurred  or  payments  continued  after  it  has  failed, 
they  are  unfair  either  to  the  utility  or  to  the  public. 


FAIR     VALUE     AND     THE     RATE     BASE         159 

And  then,  after  all,  it  is  lessening-  of  worth  deter- 
mined by  theoretical  methods  and  not  from  the  actual 
depreciated  condition  of  the  plant  that  has  been  cal- 
culated. 

The  Public  Service  Commission  of  Washington 
in  a  telephone  rate  case2  decided  April  26,  1916,  says, 
regarding  the  unfairness  of  the  use  of  fair  value : 

"It  was  never  intended  that  rate  payers  shall  be  re- 
quired to  pay  interest  to  the  "utility  upon  the  added  value 
of  its  property,  resulting  from  a  city's  paving  over  conduits 
and  mains  and  respondent  here  makes  no  such  claim;  yet 
such  value  must  necessarily  be  a  part  of  the  "fair  value' 
of  the,  property.  The  courts  never  intended  to  require  rate 
payers  to  contribute  additional  returns  to  the  utility  by  reason 
of  all  'unearned  increment,'  which  in  many  cases  if  consid- 
ered as  a  part  of  the  'rate-base,'  would  result  in  rates  abso- 
lutely prohibitive." 

The  necessity  for  allowing  return  on  the  "pres- 
ent" or  "fair"'  value  of  lands  lying  close  to  densely 
populated  centers  in  the  watershed  of  municipal  water- 
works has  in  the  past  and  is  at  present  causing  embar- 
rassment to  rate-fixing-  bodies.  One  example  of  the 
hardship  resulting  to  the  public  from  such  ownership 
is  the  instance  of  a  \Yestern  municipality  in  which  the 
charge  to  the  consumers  caused  bv  allowing  6  por 
cent  interest  on  the  present  market  value  of  water- 
shed lands  would  be  lOc  per  1000  gallons.  This 
amounts  to  about  40  per  cent  of  what  the  total  charge 
for  water  is  at  the  present  time.  The  actual  price  at 
which  land?  were  purchased  in  the  early  history  of 
the  company  was  in  the  neighborhood  of  one-fifth  of 
their  present  market  value  and  the  interest  charge  at 
the  same  rate  (6  per  cent)  on  an  investment  basis 
would  in  all  probability  be  very  much  less  than  lOc 
per  1000  gallons. 

A  Satisfactory  Rate  Base 

A  "rate-base"  is  that  amount  on  which  the  owner 
of  a  utility  is  to  be  allowed  a  return  and  it  should  be 
the  starting  point  in  all  rate-fixing  procedures. 

'Public    Service    Commission    of   Wasliin ston    vs     Pac.    Tele- 
phono  &   Telegraph   Co.      Case   No.    1S25. 


160  PUBLIC     UTILITY     RATE     FIXING 

"Present  value"  has  been  used  as  a  rate-base  and 
found  unsatisfactory  because  the  depreciated  condition 
of  the  plant  which  can  be  determined  theoretically 
has  no  direct  bearing  on  the  rates  that  should  be 
charged  for  the  services  rendered  to  the  public. 

The  "rate-base"  which  is  in  every  respect  most 
satisfactory,  is  the  legitimate,  properly  determined 
investment,  undiminished  by  depreciation,  but  with 
due  consideration  to  the  cost  of  developing  business. 
That  this  does  not  meet  the  decisions  of  the  courts 
which  demand  "value"  as  the  basis  of  the  calculation 
should  not  mislead  the  rate-fixing  authorities.  They, 
as  already  stated,  may  adopt  any  proceedings  in  fixing 
rates  that  to  them  seem  fair  and  proper.  It  rests  with 
the  courts  to  apply  the  "value"  test  when  they  are 
called  on  to  determine  the  sufficiency  of  the  rates,  if 
this  be  the  method  they  deem  proper.  In  determining 
the  rate-base,  consideration  may  be  given  to  early 
losses  of  the  business  treated  as  investment  necessary 
to  develop  the  business,  to  bonuses  or  gifts  from  the 
public  and  to  capital  which  has  been  returned  to  the 
owner. 

The  rate-base  furnishes  the  basis  or  starting  point 
for  the  calculation,  but  in  determining  the  earnings 
that  should  be  allowed  the  skill  and  efficiency  of  the 
owner  in  conducting  the  business  must  also  be  taken 
into  account.  He  is  entitled  to  a  share  in  the  pros- 
perity of  the  community  to  which  the  utility  has  con- 
tributed. Consideration  should  be  given  to  the  risks 
of  the  business  and  to  the  fact  that  the  business  was 
started  before  the  community  was  ready  to  assume 
the  burden  and  the  risk  of  operating  a  plant  itself. 

The  Supreme  Court  of  Idaho  in  reviewing  the 
decision  of  the  Public  Service  Commission  of  Idaho  in 
the  Pocatello  "\Yater  Company  case  in  19153  practi- 
cally abandoned  "present  value"  as  a  rate-base.  The 
court  states  that 

"So  far  as  the  question  of  depreciation  is  concerned,  we 
think    deduction    should    be   made   only   for   actual,   tangible 


3(150   Pac.   Rep.    47,    1915,   p.    50.) 


FAIR     VALUE     AND     THE     RATE     BASE         161 

depreciation,  and  not  for  theoretical  depreciation,  sometimes 
called  'accrued  depreciation.'  In  other  words,  if  it  be  dem- 
onstrated that  the  plant  is  in  good  operating  condition  and 
giving  as  good  service  as  a  new  plant,  then,  the  question  of 
depreciation  may  be  entirely  disregarded." 

This  decision  allowed  the  utility  a  return  on  the 
undepreciated  investment,  holding  that  theoretical  de- 
preciation can  be  disregarded  when  unaccompanied  by 
deterioration  of  service. 

Along  similar  lines  Mr.  C.  P.  Cutten,  attorney  for 
the  Pacific  Gas  &  Electric  Company,  argued  before 
the  California  Railroad  Commission  in  19144  asking 
for  a  fair  rate  of  return  on  the  investment  and  a  rea- 
sonable profit  for  the  conduct  of  the  business,  claiming 
that  there  can  be  no  possible  inducement  to  develop 
business  in  new  and  untried  territory  unless  sufficient 
return  in  the  rates  be  allowed. 

Although  numerous  arguments  for  some  basis  for 
the  fixing  of  rates  other  than  the  depreciated  value 
were  made  prior  to  1915,  no  legal  contention  for  the 
use  of  a  rate-base,  as  such,  independent  of  value,  prior 
to  that  time  is  known.  In  November,  1915,  Mr.  James 
T.  Shaw  before  the  California  Railroad  Commission 
in  a  telephone  rate  case  (Application  No.  1870)  argued 
that  "value  is  a  result  and  not  a  premise."  He  says 
that  the  premise  we  have  been  calling  "value"  is  not 
value  but  is  a  rate-base,  value  being  the  result  experi- 
enced from  skill  and  integrity  or  the  lack  of  them  in 
the  management  of  a  property  under  rates  determined 
from  this  base.  Mr.  Shaw  contended  for  a  "rate-base" 
which  represents  actual  performance.  Actual  perform- 
ance, he  argues,  is  "a  literal  and  itemized  presentation 
of  that  which  we  own,  compiled  in  the  held  by  actual 
identification  and  count  checked  and  verified  by  Com- 
mission engineers  and  representatives."  Continuing 
he  states : 

"From  this  inventory,  can  be  determined  the  physical 
factors  to  be  appraised  for  inclusion  in  the  Rate-Base  *  *  * 
That  which  is  excluded  from  the  Rate-Base,  if  appraised  at 
all.  will  be  appraiser!  only  because  of  and  with  due  regard 


4To\vn  of  Antioch  vs.  Par.  Gas  and  Elec.  Co.    Case  No.   400. 


PUBLIC     UTILITY     RATE     FIXING 

to  some  of  the  elements  of  value  first  discussed.  But 
whether  appraised  or  not,  it  is  foolish  to  say  that  it  is  without 
value.  That  which  is  included  will  be  appraised,  not  for  its 
value,  but  for  its  weight  as  a  factor  in  the  ultimate  Rate- 
Base."  The  weight  to  be  given  that  which  is  included  will 
be,  he  states,  "the  Company's  Actual  Performance  as  ex- 
pressed in  actual  investment  in  the  now  operating  property 
used  and  useful  in  rendering  the  services  that  'the  people  of 
California,  through  its  railroad  commission,  now  require  of 
them." 

In  mentioning  this  case  in  its  annual  report5  the 
California  Railroad  Commission  states : 

"This  proceeding  necessitates  a  valuation  of  all  the  tele- 
phone property  of  this  utility  in  the  state,  and  also  requires 
the  determination  of  a  proper  rate-base  *  *  *" 

The  decision  in  this  case  has  not  yet  been  rendered 
by  the  Commission. 

The  Pacific  Telephone  &  Telegraph  Company  has 
made  precisely  similar  contentions  for  a  rate-base 
before  the  Public  Service  Commissions  of  Washington 
and  Oregon.  The  decision  in  the  Washington  tele- 
phone rate  case  which  was  rendered  on  April  25,  1916, 
(Xo.  1825).  Commissioner  A.  A.  Lewis  does  not  adopt 
as  a  principle  the  "actual  performance"  method  of 
appraisal,  but  does  concur  with  the  views  of  the  attor- 
neys for  the  telephone  company  as  to  the  necessity  for 
the  use  of  a  "rate-base"  distinct  from  fair  value.  The 
Commissioner  states: 

"That  fair  value  if  the  words  are  to  be  used  in  their 
usual  and  ordinary  sense  cannot  be  the  basis  for  rates,  that 
a  utility  is  entitled  to  reasonable  compensation  based  upon 
the  reasonable  and  necessary  detriment  suffered  in  prepara- 
tion for  and  in  the  service  of  its  patrons,  and  not  upon 
values  created  by  the  public." 

The  Commission  in  its  findings  adopts  a  "rate- 
base"  as  the  basis  for  fixing  the  rates.  The  decision 
made  is  : 

"That  the  fsir  value  of  the  respondent's  entire  property, 
or  rate-base  from  which  should  be  estimated  the  just,  fair, 
reasonable  and  sufficient  return  to  respondent  as  of  Decem- 
ber 31,  1914,  is  the  sum  of  $19,382,209." 


•'•(July   1,   1915 — June   30,   1916,  Vol.   1,   p.   84.) 


FAIR     VALUE     AND     THE     RATE     BASE         163 

This  amount  is  more  than  the  cost  of  construction 
and  equipment  ($18,467,296.41),  more  than  the  cost 
of  reproduction  new  ($17,147,592.07),  more  than  the 
cost  of  reproduction  in  its  present  condition  ($14,- 
011,297.48)  and  it  is  less  than  the  total  market  value 
of  the  property  ($22,000,000). 

In  this  case  the  reproduction  cost  found  by  the 
engineers  of  the  Commission  as  of  date  December  31, 
1913,  was  $16,765,383,  and  the  development  cost  at  8 
per  cent  upon  the  investment  was  $2,396,400  as  of 
same  date.  The  sum  of  these  two  figures  being  $19,- 
161,783.  The  engineers  for  the  telephone  company 
found  an  "actual  performance  appraisal"  based  on  the 
company's  actual  investment  in  the  now  operating 
property  in  the  sum  of  $19,246,088.  The  method  by 
which  the  Commissioner  obtained  his  figure  of  $19,- 
382,209  is  not  definitely  stated  in  his  findings. 

The  Present  Situation 

The  science  of  valuation  is  still  in  a  formative 
stage  and  the  rate-base  distinct  from  "present  or  fair 
value"  has  only  recently  been  recognized  by  the  rate- 
fixing  bodies.  The  following  questions  demand  definite 
answer: 

(1)  Do  the  Supreme  Court  decisions  make  it  ille- 
gal for  a  Commission  or  other  rate-fixing  body  to  use 
a  rate-base,  distinct  from  value,  in  fixing  rates? 

(2)  Is  not  the  use  of  the  terms  "fair  value"  and 
"present  value"  by  the  courts  the  result  of  the  neces- 
sity   for    determining    whether    confiscation    has    oc- 
curred? 

(3)  If  the  earnings  include  a  reasonable  rate  of 
interest   return   on   the   capital   properly  invested,   due 
regard   being  given   to  the   ha/ard,   the   compensation 
for  management  and  the   participation  of  the   utility 
in  the  general  prosperity  of  the  country,  can  confisca- 
tion take  place  or  can  the  public  be  deprived  of  any  of 
its  rights? 


164  PUBLIC     UTILITY    RATE     FIXING 

It  is  extremely  desirable  that  engineers  and  econ- 
omists direct  constructive  thought  towards  the  funda- 
mental principles  of  rate-fixing.  Ignoring  them  at  this 
time  only  postpones  the  final  settlement. 


INDEX 

Page  Page 

Accrued    Depreciation 25,    90  — of     developing     business     in 

Alvord,    J.     W.,    quoted    on    de-  relation   to    going   value 53 

preciation 1        Courts   and   rate   fixing   authori- 

American    Soc.    C.    E.    report   of  ties    have    different    functions  156 

committee   on   valuation 29,  156        Crystal   Springs   reservoir  lands, 

Appreciation 27,    90,    96-100  value    of    77 

— and  dedication  to  public  use  19        Current   depreciation   or  the   re- 

— and   depreciation,   treatment  placement   requirement  12 

compared  100        Cutten,     C.     P.,     holds    that    the 

— and  general   prosperity 19            rate   of   return    should   be    ap- 

— in   relation  to   public   utility  plied    to    the    investment 161 

rates   96        ~           ... 

-and    the   rate   base 19        Depreciation,  the  accrued  should 

-in     the     Western     Advanced  '"V^   1     w '    *'J   '        '      ? 

Rate  case  by  the   Interstate  -Alvord     J.    W.,    quoted.... 

Commission  .  .  99  -current,  or  the  replacement 

-where  it  should  cease  to  requirement  .... 

appear  in  the  rate  base....  97  ~dof  not  a?ect  the  stand' 

— U.  S.  Supreme  Court  cited  ar£  °ff  serv,lce V"n '  o 

in  the  Consolidated  Gas  Co.  -difficulty    of    ascertammg....     29 

cage  gy  — ordinary  formulas  for  com- 

Appreciation"  of"iand""""":59r66';  73  l)uti.n.K  jlre  inaccurate  math- 

-in  the  San  Francisco  Bay  ematical  demonstration  .....91-94 

region  67-74  -treatment  of,  compared 

-in  the  San  Francisco  Bay  ™.th  treatment  of  appreci- 

region    compared     with    the  _  ™T""i7 

growth  of  population 73  Development  expense,  Metcalf, 

Leonard  quoted  56 

Bonus    and    the    rate    base 14        Earl>'  losses  in  relation  to  going 

Boom    Co.    vs.    Patterson,    cited  value    ..                                                  54 

on    value   of    land    for    special  Earnings,    the    adequate    include 

purposes    .  82            a    l'ront    -• 

-    the    excessive    8 

Calaveras    reservoir    lands,    val-  — tlle   P*st.   how  to  be  consid- 

ue    of    79                ere*  - 

California  Railroad  Commission,  --and    the   rate  of   return 

on     the     necessity     for    deter-  Electric    energy    rates 

mining    a    proper    rate   base....   162        Eminent   domain   proceedings 81 

California  State  Supreme  Court,  Expectation  of  the  term  useful- 

in    San    Diego    Land    &    Town  ness    ils    affecting    rates 30 

Co     vs.    Geo.    Neale    et    al    on  Farrington.    Judge    E.    S.,    cited 

land^ value    ..  in    reference    to    the    va]ue    of 

—in  Sacramento  Southern  Rail-  reservoir      land      near      San 

road    Co.    vs.    Heilbron  on   ad-  Francisco                                         76-80 

missability  of  evidence  inland  .    citd  'on    water'"rig'ht"  values 

condemnation     proceedings...  near    gan    Francisco                   m 

Capital,    when    to    be   considered  Fortuitous    events,    amortization 

retired    out    of    earnings 9             ,,f    ]osse^     from                                     39 

Chandler-Dunbar    Water    Power  —effect 'thereof"  upon"  rates""     40 

Co.      the     case    of     U.     S.     vs.  _    who   shou!(i   bo;lr   tne    Iosses 

cited    on    value    in    condemna-  resulting  therefrom    ...            .     41 

proceedings    83 

Condemnation   of   land    for   pub-  Gas    and    waler    rates 143 

lie   use 81        General    prosperity    is    increased 

Consolidated  Gas  Co.  case   (Win.  by     the    establishment    of    the 

R.     Willcox     vs.     Consolidated  public     utility     42 

Gas    Co.    of    N.     Y.)     cited    on  Georgia     Railway     Co.     vs.     Ala- 
appreciation    07             bama      Railroad      Commission, 

-   cited   on   the    rate   of    return  132             cited   in    reference   to   right-of- 

Cost.   the  original   and   the  legit-  way     value    87 

imate    investment 6        Going   value 5,    8, 

—  of  reproduction  and  the  nat-  27.    -19,    50.    51,    o'_'.    53,    54,    55.    56 

ural     rate    base fi                 Brewer.     Justice     I'.  S.     Su- 

— of   developing   business 7  preme    Court    quoted 50 

165 


166  PUBLIC     UTILITY     RATE     FIXING 

Page  Page 

cost  of  developing  business                   — should    be    adequately    pro- 
as  a   measure   thereof 51,  54  tected    121 

cost   of   developing   business  Knoxville      waterworks      case, 

is    not   the    going   value 53  cited   on   past   history 6,    7 

— determination    of    51 

Hazen,    Allen,    quoted 56        Lake    Merced,    San    Francisco, 

—in    its    relation    to    the    vol-  California    154 

ume   of   business 55        Land,  value  of 59,  60 

—in    the    San    Francisco    rate  —earning  capacity  as  a  basis 

case    49  of    its    value 60 

—how  affected  by  early  losses  54  —See:    real    estate, 

—hypothetical  reproduction  as  Lewis,     A.     A.,     of    the    Public 

an    aid    in    determining    the  Service   Commission  of  Wash- 

sarre  52  ington,     contends    for    a    rate 

— MorrowV'judge'w.'w! '"quoted  50  base    which    is    not   value 162 

—not    dependent    on    the    in-  Lux   vs.   Haggin,    referred   to   in 

vested    capital    55  relation   to   riparian   rights 110 

— the  basis   thereof   is   found   in 

the    earnings    55,  60 

—Van    Fleet      Judge     W.     C.  Management,   compensation   for, 

'  .    .  50  may  appear  as  interest  on  the 

— Wright,'"H.'~"M.7' Master  "in  ^oing    value    42 

Chancerv,     San     Francisco  —compensation     for     can     be 

water   rate    case   quoted 49  brought    into    relation    to    the 

-U.  S.  Supreme  Court  quoted  50  volume    of    business  43,    45 

Goose  Lake.  California,   cited  as  -compensation      therefor 

an    undesirable    storage    site....  65  should     not     be     based     on       - 

Grunsky,    Capt.    C.    E..    Jr.,    on 

"Fair     Value     and     the     Rate  —hazard     and     the     unearned 

Base,"    Chap.    X 156-164  increment      

Government    ownership    of    rail-  Market    value     (see    Value) 

roads  150       Mathematical    demonstration    of 

error  in  the  ordinary  formu- 
las for  depreciation  and  pres- 
ent value  92 

Hazard,     compensation    therefor  Merced  Lake,   in  San  Francisco, 

may    appear    in    the    rate    of  value    of    site 75 

return  applied  to   going  value  42  — cited    as    having    value    due 

— compensation      therefor  to    storage    capacity    rather 

not    be    brought    into    rela-  than   to   water   production....   154 

tion    to   value 41,  43        Metcalf.  Leonard,  quoted  on  de- 

— in  the  Consolidated  Gas  Co.  velopment    expense    56 

case 41        Methods    of    procedure    in    rate 

— management,     and    the    un-  fixing    illustrated    20 

earned    increment    41        Minnesota    rate    cases,    cited    on 

— the    volume    of    business    as  the     right    of    way     and    land 

a    basis     for    an    allowance  value    86 

therefor    43,  45        Morrow,    Judge    W.    W.,    quoted 

Har.en,    Allen,    quoted    on    going  on    going   value 50 

value    ••••  56 

— quoted  on  appreciating  land 

values     in     the     San     Fran-  Natural  rate  base 3,   6,   29,   151 

Cisco    water    rate    case Obligation    of    the    publin    when 

Hjpothetica!  reproduction  as  an  it   reffuiatea  pubnc  utilities 127 

aid   in  estimating  going  value  52        obsolescence,  defined  34 

— ran    not    be    forecast 34 

— past  experience  is  not  a  de- 
Idaho      Supreme     Court,_     aban-  pondahle  guide  for  its  deter- 
dons     "present    value        as    a                        mination  ...  .     35 
rate     base     in     the     Pocatello                    _and      replacement      reauire- 

water  rate  case  menif     compared     35 

Intangible    elements    of    value....  —should     affect     rates     subse- 

Intangible   elements    have    value  quent  to  and  not  before  the 

as   the    result    of    earnings.. ..52,  5  event  36 

Interest    and   rate  of   return illustration 

Interstate     Commerce     Commis-  Owners'  of    public" "util'i ties'." "the 

sion,     cited     in     the     \Vestern  ri   hts    of    2g 

Advanced    rate    case 99 

Inventions,      their      introdu'-tion 

should   be   rewarded 11        Pacific    Telephone    &    Telegraph 

Investment,  and  the  natural  rate  Co.,     contend:-!     for     a     proper 

base 3.    6,  151  rate    base    162 


INDEX  167 

Page  Page 

Peninsula     reservoirs     of     the  — value    as    a    rate    base,    not 

Spring  Valley   Water  Co.   sys-  satisfactory    2,     161 

teni    supplying    water    to    San  Rate  Fixing,  elements  requiring 

Francisco,    value   of 77  consideration    34 

Pilarcitos  reservoir  lands,  value  — fundamental    principles,    il- 

of 77  lustrated  20 

I'ocatello   water   rate  case,   cited  railroads   20 

on    the    abandonment    by    the  steamboat    22 

Idaho  Supreme  Court  of  pres-  waterworks    23 

ent   value  as  a  rate  base 160  — general     comments    on 1 

— cited    on    accrued    deprecia-  — unlimited    life    method 33 

tion  14        Rate  of  return  121,   125 

Population     growth,     California  — illustrations    128 

and    the    San    Francisco    Bay  — in  the  San   Francisco  water 

region   71  rate  case   132-134 

Population  growth  and   appreci-  Rate  payers,   the  rights  of 27 

ation    of    real    estate 67-75       Rate   Schedule   135 

— Alameda    County,     Cal 74  — problems   relating  to 136 

— Contra    Costa    County,    Cal.     72  — and     the     unearned     incre- 

— San     Francisco     City     and  ment   138 

County,    Cal 68  — determining  factors  139 

— San    Mateo    County,    Cal 69  — electric    energy    rates 141 

— Santa   Clara   County,    Cal 70  — gas    and    water    rales 143 

Present   value   as   a   rate  base..-.  — remission  of  taxes  as   affect- 

2,    27,    91,    151,    152,    158,    160  ing 139 

Probable    life    of    articles    does  — railroad    rates    147 

not    agree    with    their    actual  — Street   car   fare 145 

terms    of    usefulness 30  Rates    are    not    uniform    to    all 

-  -mathematical  demonstration  rate    payers    135 

of    error    in    the    calculation  Rates,   should   not  be  affected  by 

of  present  value  and  of  de-  accrued    depreciation    2 

preciation   due   to   this    non-  —-how    affected    by    fortuitous 

agreement   31,    92  events    39 

Profit,  in  its  relation  to  value....     10  — how     affected     by     obsoles- 

— in   its  relation  to  volume  of  cence    36 

business    10,    47,    48  Real    Estate    appraisal    for    spe- 

—  as    a    reward    for    skill    and  cial    use   59 

good    management    11  -court    decisions    on    market 

Public,    the    rights   of   the 28  value  of  82 

—its  obligations  when  it  reg-  — in     condemnation      proceed- 

ulates   public   utility   rates....   127  ings,     admissibility     of     evi- 

Public     Service     Commission     of  dence  84,   85 

Washington   on   the   rate   base  — value    of    for   ordinary    uses     88 

in     the    telephone     case 162  — value     in     eminent     domain 

Public    Utilities    and    general  proceedings    81-89 

prosperity    97  Real    estate    in    the    San    Fran- 
Public   utility,   the,   and   the   un-  cisco     Bay     region,    increasing 
earned    increment    15,    97            value    of    67 

-  the,     may     be     regarded     as  — Alameda    County,    Cal 74 

having   unlimited    life 33,    90  — Contra    Costa    County,    Cal.     72 

— S>an     Francisco     City     and 

County,    California   68 

Railroad     Commission     of     Cali-  —San    Mateo    County,    Cal 69 

fornia    on    necessity    of   estab-  — Santa   Clara   County,    Cal 70 

lishing    a    proper    rate    base....   162  Replacement    requirement     (cur- 
Railroad     rate    schedule 147            rent    depreciation)    12 

the     long     and     short     haul  — determination      of       current 

question   147  replacement   requirement    is 

Railroad    rates,    require    adjust-  essential    95 

trent    to   a    number  of   factors   150  Replacement   (depreciation)   fund     13 

Railroads    in    competition     with  Reservoir  lands    not    yet    in   use. 

water    transportation    149  value    of    80 

Rate   Base  2,   3,  Reservoir     lands,     factors    to    be 

1-2.    14,    15.    16.    19.    151,    152.    160  considered   in    making  the   ap- 

and    appreciation   19,    152  praisal     61 

and     the    bonus 14  -    market    value    is    difficult    to 

and   donated    property 15  determine     66 

-  and    value    of    water    rights      16  sale*    of    similar    properties 

-  court     decisions     imixjse    re-  considered     62 

strictions    upon    152  value  of  59 

--the    natural    3,    6.    20,    151  -value    of,     near    San     Fran- 

— the   satisfactory   159,    160  cisco    ...                                               fifi 


168 


PUBLIC     UTILITY     RATE     FIXING 


Page 

Reservoir  for  storage  reduces 
waste  63 

Reservoirs  of  the  San  Fran- 
cisco Bay  region 64 

Reservoir  site,  determination  of 
availability  62 

Reservoirs  of  large  extent  may 
have  small  storage  value 64 

Rights  of  way,  the  value  mul- 
tiple   85 

Riparian  rights,  doctrine  estab- 
lished in  California 110 

Rudkin,  Judge  F.  H.,  on  the 
rate  of  return  in  the  San 
Francisco  water  rate  case 134 

San  Andreas  reservoir  lands, 
value  of  77 

San  Antonio  reservoir  site, 
value  of  78 

San  Francisco  Bay  region,  in- 
creasing value  of  real  estate  67 

San  Francisco  City  and  County, 
growth  of  population  and  in- 
creasing value  of  real  estate  68 

San  Francisco  water  rate  case, 
see  Spring  Valley  Water  Co. 
vs.  San  Francisco. 

San  Joaquin  and  Kings  River 
Canal  and  Irrigation  Co.  vs. 
the  County  of  Stanislaus,  de- 
cision of  the  U.  S.  Supreme 
Court  on  water  right  value....  102 

San  Mateo  County,  Cal.,  growth 
of  population  and  increasing 
value  of  real  estate 69 

Santa  Clara  County,  Cal., 
growth  of  population  and  in- 
creasing value  of  real  estate  70 

Service,  quality  of  by  public 
utility  unaffected  by  depreci- 
ation    2 

Shaw,  Jas.  T.,  quoted  in  favor 
of  a  rate  base  which  differs 
from  value  161 

Smyth  vs.  Ames,  U.  S.  Supreme 
Court  cited  on  reasonableness 
of  rates  156 

Spring     Valley     Wa'.er    Co.    vs. 
San  Francisco   (San  Francisco 
water  rate  case),  49,  50,  50.  75,  79, 
109,    111,    116,    132,    133,    152,    154 

Steamboat,  as  an  illustration  of 
methods  of  procedure 3 

Strategic   value   of   water  rights  105 

Street   car   fare 145 

--the   zone   system 146 

Street    car    operation,    essentials   147 

Supreme  Court  of  California, 
see  California  Supreme  Court. 

Supreme  Court  of  Idaho,  aban- 
dons present  value  as  a  rate 
base  160 

Supreme  Court  of  the  United 
States,  see  U.  S.  Supreme 
Court.. 

Taxes,  assessed  to  public  util- 
ities   139 

Thorintrton,  Special  Master, 
cited  on  right  of  way  value 
in  Georgia  Railway  Co.  vs. 
Alabama  Railroad  Commission  87 


Page 

Tulare  Lake,  Cal.,  cited  as  of 
small  value  for  storage 65 

Unearned   increment   

15,   19,  41,   42,  43,   45,  138 

Unearned  increment,  allowance 
for  participation  in  general 
prosperity  brought  into  rela- 
tion to  the  volume  of  busi- 
ness   43,  45 

— allowance      therefor     should 

not    be    based    on    value 41 

— allowance  therefor  may  ap- 
pear in  the  rate  of  return 

applied  to  going  value 42 

— of  property  owners,  gen- 
erally, is  affected  by  the  es- 
tablishment of  a  public 

utility   15 

— and    the    public    utility 42 

— and    the    rate    schedule 138 

Unlimited  life  method  of  pro- 
cedure in  fixing  rates 33,  95 

Unlimited  life  of  public  utilities    90 
United    States    Supreme    Court, 
in  Doom  Co.  vs.  Patterson  on 
the   value   of   land   for   special 

purposes    82 

— in     Consolidated     Gas.     Co. 

rate    case,    on     appreciation     97 
— in    KnoxviMe    water    rate 

i-afe    on    depreciation :..  6,    7 

— in   Minnesota  rate  cases,  on 

the   value   multiple 86 

— in  San  Joaquin  and  Kings 
River  Canal  and  Irrigation 
Co.  vs.  the  Ccunty  of  Stan- 
islaus, on  the  value  of 

water    rights    102 

— in   Smyth   vs.   Ames,   on   the 

reasonableness    of    rates 157 

— in  United  States  vs.  C'nand- 
ler-Dunbar  W  a  t  e  r  Power 
Co.  on  the  value  of  land....  83 

'Valuation,  Depreciation  and  the 
Rate  Base.'  by  C.  E.  Grun- 
sky,  quoted  on  past  history  of 
the  public  utility 7 

—  -quoted    on    the    replacement 

requirement   95 

-  quoted  on  water  right  value    16 
VaU'.r.tion    for    rate    fixing    pur- 
poses,   in   a   formative  stage....   163 

-  -of    reservoir    lands,     factors 

to   be   considered 61 

---'"or    taxation    purposes,    San 

Francisco    Bay    region 73 

Valle   reservoir   site,    Cal.,   \alue 

of 78 

Value— 

—  as  a  rate  base  illogical   and 
impractical    2,    151,    158 

— as  a  rate  base  and  invest- 
ment contrasted  27 

of    irrigation    water    101 

of    Innd,    circumstances    af- 
fer;in.sr    59 

-  -of    reservoir    lands    59 

of    reservoir    lands    not    yet 

in    use    ..  .     80 


INDEX  169 

Page  Page 

—of  reservoir  land  in  the  San  Volume     of     business,     as     the 

Francisco    Bay    region 75  basis  for  a  profit  allowance  10,  20 

— of  reservoir  land  in  the  San  — and   public   utility   rates 

Francisco   Bay  region  is  in- 43,    45,    46,    48 

creasing    67  Washington,   State   Public   Serv- 

— of   a   water   right ice    Commission,    on    the    rate 

16,   18,   25,   85,    101-103,   105,  base    in    the    telephone   case....  162 

108,    108,    112-114,    116,    117,    119  Water     power,     compared     with 

Anderson,  Geo.  G.  in  ref-  steam   power   18 

erence    to    116  - — development    of     should     be 

Hermann,    F.    C.,    in    ref-  encouraged    107 

erence    to    116       Water   rates   143 

Lee,    C.    H.,    in    reference  Water    right    value,    see    "Value 

to 116  of   a   water   right." 

affected    by    its    life 108  "Water     transportation,      in     its 

created    by    earnings 1(  efTeet    u  railroad    rates 149 

by    comparison    with    val- 
ues  elsewhere                       112  Water-works,     valuation     as     a 
is    affected    by    additional  basis    for   rates>    illustration....     25 

development  of  water....   113  Wright,     H.     M.,     Master    in 

indicated   by    sales   of  the  Chancery,       San       Francisco 

stock   of   mutual   irriga-  water     rate    case — 

tion   water  companies....  114  — quoted  on  going  value 49 

determined    from    the    en-  - — quoted    on    rate    of    return 

hanced     value     of     irrl-  for   a   going   concern 57 

gated    land    117  — quoted   on   the   rate   base   in 

is    affected    by    an    obliga-  the     San     Francisco     water 

tion  to  supply  water  at  rate    case    152 

less     than     cost 119  — quoted    on    the    rate    of    re- 

and    the    rate   base 16  turn    in   the    San    Francisco 

may  be  strategic  value 105  water    rate    case 132 

in     the     San     Francisco  — quoted     on     reservoir     land 

water    rate    case 109  value   in   the   San   Fram-isro 

Value    multiple,     as    applied    to  water  rate   case 75-80,    154 

rights    of    way 85  — quoted   on    water   right   val- 

Van   Fleet,  Judge  W.  C.,  quoted  uea    in    the    San    Francisco 

on  going  value  50  water    rate    case 109-112 


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